NSE's CERTIFICATION IN FINANCIAL MARKETS
Commodities Market Module Work Book
NATIONAL STOCK EXCHANGE OF INDIA LIMITED
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.......................................................................................
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
.............................2 Clearing banks .............. Clearing and settlement....2 Settlement methods .......................... 8................. 7.............1 Futures trading system ........................................................1..............................................................................................1.......4 Hedge ratio .........2 Underpriced commodity futures: buy futures.... 7.......................................... 8...2 Short hedge..........2................................3 Long hedge .1 SPAN .............2...............................................................................................................................................................................1.... 7. 9.................... 8........ 9.5.................... 8......
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
.....5....................................... 9........................................ 9........3..............1............4.............................2..... 8................................................... 8...........................5.................................3 Arbitrage .......................2................1.................6 Limitation of hedging: basis Risk ...............................2 Entities in the trading system ............................................................................................................ 7..3 Depository participants ................................ sell futures ............... sell futures .............................. Clearing mechanism .....1 Settlement mechanism.......................................................................................................................5.............................................................2.... 7........................................................................................... 8.......................................... 8...................................... buy futures ........................................................3 Risk management .....................1 Overpriced commodity futures: buy spot.............................2 Speculation: Bearish commodity..................1 Hedging ........... 9.............5 Advantages of hedging ............................4 Base price ..........1................................1 Clearing.5.....1.CONTENTS 7 Using commodity futures .................. 8.1........................................................ 7........... 8.........5....................3....................3 Quantity freeze ...............2.............. 8........... 7......1 Speculation: Bullish commodity......4 Margining at NCDEX ............ 7............................ 9.............................................................................. 7.........4 Commodity futures trading cycle...................2 Speculation ..................................................1 Guidelines for allotment of client code..7 Charges .................................. 8.............................................................. 8......................................................6 Margins for trading in futures ............ 9.........3 Entities involved in physical settlement ............................ 7.................................2 Tick size for contracts ........................................................................... 9..................5 Price ranges of contracts ................... 9.......................................................................1 Permitted lot size .................... 9..........................................................................................................................................................1.................6 Order entry on the trading system ............................. sell spot ...........1 Basic principles of hedging . 7.......................... 9.............1................3 Contract specifications for commodity futures ............................5 Order types and trading parameters .... Trading ............................................... 7................ 8. 7.....................................2 Settlement ..................
....................4........... 10.......................... 10.............................6 9.....................5 10
CONTENTS Initial margin ........................................... 10......................2 Rules governing intermediaries ...................................2.............. 126 126 128 130 135 135 136 136 140 144 145 146 149
Regulatory framework .................2 Clearing ............... Implications of sales tax .......... Effect of violation..........................................1 Trading ................................................................................. Implementation aspects of margining and risk management .......1 Rules governing commodity derivatives exchanges ..................4..........................................4.. Computation of initial margin .............3 Rules governing investor grievances....3.................4..2 9.........2 Hearings and arbitral award ........................................ 10................................................................ 10.................................... 10........................4 9...................
................3 9...............3...........................1 Procedure for arbitration ...2................... 10............................................ arbitration ........................................
2...........................................1 The global derivatives industry...................................................................... 72
5......................1 Distinction between futures and forwards ....List of Tables
3..........indicative ware house charges.................1 Country-wise share in gold production..........................2 Fee / deposit structure and networth requirement: PCM ........2 Silver futures contract specification .................
2.................. 1968 and 1999 .......... 33
3......1 NCDEX ........2 Volume on existing exchanges .................. 33
....................2 Distinction between futures and options...................................................1 Refined soy oil futures contract specification...............3 Registered commodity exchanges in India ....................................
5...............................1 Fee / deposit structure and networth requirement: TCM .................
.................................5 Commodity futures: Lot size another parameters ..........................6 Number of days for physical settlement on various commodities .............. 111
8..1 MTM on along position in cotton futures ........... 120
9...........................3 Long staple cotton futures contract specification .....3 Gold futures contract specification .......................1 Commodity futures contract and their symbols ................................................................. 130
8......5 Exposure limit as a multiple of liquid net worth.........................2 MTM on a short position in cotton futures ...................4 Commodity futures: Quantity freeze unit ............................8
List of Tables
7....4 Minimum margin percentage on commodity futures contracts ....2 Gold futures contract specification ................... 103
9....................................................................3 Calculating outstanding position at TCM level ...... 105
........... 5............................................ 5..................................8 Payoff for writer of put option on long staple cotton...................................................................................................................................................................1 Payoff for a buyer of gold ........................................... 5........................................1 Variation of basis overtime ...............................2 Payoff for buyer of a long hedge ........................... 7........................................ 5........................................7 Payoff for buyer of put option on long staple cotton ......................5 Payoff for buyer of call option on gold.......3 Payoff for a buyer of gold futures .6 Payoff for writer of call option on gold ........1 Payoff for buyer of a short hedge .......... 5.......................... 5...List of Figures
5........................................... 7..... 66 66 67 68 69 70 71 72 84 88 90
8....................... 6...........................................4 Payoff for a seller of cotton futures .......................................................................................2 Payoff for a seller of gold ........... 106
.............1 Contract cycle .................................................................. 5.........................
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
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1. or CBOT. he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty. From the time it was sown to the time it was ready for harvest. silver. it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. cotton. commodity
. 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.1
A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner.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. etc. although favourable prices could be obtained during periods of oversupply. the Chicago Board of Trade. Besides commodities. a merchant with an ongoing requirement of grains too would face a price risk .that of having to pay exorbitant prices during dearth. On the other hand. was established to bring farmers and merchants together. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. What they would then negotiate happened to be a futures-type contract. exchange rate. In 1848. wheat. forex. which would enable both parties to eliminate the price risk. etc. These to-arrive contracts proved useful as a device for hedging and speculation on price changes. Under such circumstances. In years of scarcity. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. derivative contracts exist on a variety of commodities such as corn. Today. during times of oversupply. he would probably obtain attractive prices. 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. The underlying asset can be equity. and in 1925 the first futures clearing house came into existence. Through the use of simple derivative products. These were eventually standardised. interest rate. derivatives contracts also exist on a lot of financial underlyings like stocks. farmers would face price uncertainty. However.
2 Products. share.
1. they see the futures price of an asset getting out of line with the cash price.
1. regulation of derivatives came under the perview of Securities Exchange Board of India (SEBI). regulates the forward/ futures contracts in commodities all over India. Hedgers: The farmer's example that we discussed about was a case of hedging. 1956 (SCRA). The Securities Contracts (Regulation) Act.hedgers. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying" in this case. However when derivatives trading in securities was introduced in 2001. 2. 1952. 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. they increase the potential for large gains as well as large losses. of underlying securities. speculators. They use the futures or options markets to reduce or eliminate this risk. The most common ones are forwards. As a result of this leveraged speculative position. A security derived from a debt instrument. was amended to include derivative contracts in securities. derivative markets performs a number of economic functions. In our earlier discussion. Futures and options contracts can give them leverage. by putting in small amounts of money upfront.
Whether the underlying asset is a commodity or a financial asset. risk instrument or contract for differences or any other form of security. the term "security" in the Securities Contracts (Regulation) Act. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Speculators: Speculators are participants who wish to bet on future movements in the price of an asset. A contract which derives its value from the prices. futures.
3. and arbitragers. that is. The Forwards Contracts (Regulation) Act. 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. options and swaps. 2. participants and functions
Derivative contracts are of different types. or index of prices. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity forward/ futures contracts. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy between prices of
the same product across different markets.
. Consequently. Hedgers face risk associated with the price of an asset. loan whether secured or unsecured. Participants who trade in the derivatives market can be classified under the following three broad categories .12
Introduction to derivatives
or any other asset. for example. Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. If. Thus derivatives help in discovery of future as well as current prices. they can take large positions on the market. 1956 (SC(R)A) defines "derivative" to include 1. they would take offsetting positions in the two markets to lock in the profit. We thus have separate regulatory authorities for securities and commodity derivative markets.
With the introduction of derivatives. due to their inherent nature. They often energize others to create new businesses. As the name suggest.3 Derivatives markets
Derivative products initially emerged as hedging devices against fluctuations in commodity prices. commodity derivatives markets trade contracts for which the underlying asset is a commodity. In the absence of an organised derivatives market. Financial derivatives markets trade contracts that have a financial asset or variable as the underlying. However. 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. It can be an agricultural commodity like wheat. interest rates and exchange rates as
1. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The lower costs associated with index derivatives vis-a-vis derivative products based on individual securities is another reason for their growing use. especially among institutional investors. The more popular financial derivatives are those which have equity. etc or precious metals like gold. speculators trade in the underlying cash markets. these products have become very popular and by 1990s. who are major users of index-linked derivatives. their complexity and also turnover. Derivatives have a history of attracting many bright. • Speculative traders shift to a more controlled environment of the derivatives market. new products and new employment opportunities.1. the market for financial derivatives has grown tremendously in terms of variety of instruments available. they accounted for about two-thirds of total transactions in derivative products. well-educated people with an entrepreneurial attitude. • Derivatives markets help increase savings and investment in the long run. rapeseed. • An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. etc. monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. Margining. the benefit of which are immense. are linked to the underlying cash markets.3 Derivatives markets
Derivative markets can broadly be classified as commodity derivative market and financial derivatives markets. In recent years. creative. In the class of equity derivatives the world over. futures and options on stock indices have gained more popularity than on individual stocks. Box 1. • Derivatives. cotton. since their emergence. silver. The transfer of risk enables market participants to expand their volume of activity.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. soybeans.
They agree upon this price and Aditya buys 20 grams of gold. On 1st January 2004. 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. This is a spot transaction. let us try to understand the difference between a spot and derivatives contract. The trading happens today. A buyer and seller come together. Forward contracting dates back at least to the 12th century.030 and collects his gold. futures and options which we shall discuss in detail later.990. He pays Rs.trading. Note that the value of the forward contract to the goldsmith varies exactly in an opposite manner to its value for Aditya. in this case gold. negotiate and arrive at a price. clearing and settlement does not happen instantaneously.3.015. The exchange of money and the underlying goods only happens at the future date as specified in the contract. This is trading. clearing and settlement happens instantaneously. The contract has now lost value from Aditya's point of view. i. Settlement is the actual process of exchanging money and goods. A forward is the most basic derivative contract. This is a forward contract. No money changes hands when the contract is signed.1 Spot versus forward transaction
Using the example of a forward contract. gold trades for Rs. and may well have been around before then. takes the gold and leaves.000 per 10 grams.6. The goldsmith quotes Rs.015 per 10 grams.5.
1. They agree upon the "forward" price for 20 grams of gold that Aditya wants to buy and Aditya leaves. Now suppose Aditya does not want to buy the gold on the 1st January.6.6. 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. If on the 1st of February. Later
. for a stated price and quantity. but the clearing and settlement happens at the end of the specified period. he pays the goldsmith Rs. The most commonly used derivatives contracts are forwards.2 Exchange traded versus OTC derivatives
Derivatives have probably been around for as long as people have been trading with one another.000. 12. the price of gold drops down to Rs.6.050 in the spot market.50 to B. a contract by which two parties irrevocably agree to settie a trade at a future date. If however.015 for the same gold. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. he is worse off because as per the terms of the contract. In a spot transaction.
1. Every transaction has three components . We call it a derivative because it derives value from the price of the asset underlying the contract. but wants to buy it a month later. The goldsmith quotes Rs. 12.6.14
Introduction to derivatives
the underlying.e. that is exactly how much of goods and money the two should exchange. In a forward contract the process of trading. A month later. Consider this example. For instance A buys goods worth Rs. Clearing involves finding out the net outstanding. On a net basis A has to pay Rs.3.100 from B and sells goods worth Rs. clearing and settlement. Aditya wants to buy some gold. he is bound to pay Rs. the trading. "on the spot". Over the counter(OTC) derivatives are privately negotiated contracts.50 to B.
Commodity derivatives the world over are typically exchange-traded and not OTC in nature. these contracts were called "futures contracts". There are no formal centralised limits on individual positions. Eurex etc. To deal with this problem. There are no formal rules for risk and burden-sharing. While both exchange-traded and OTC derivative contracts offer many benefits. MATIF in France. The recent developments in information technology have contributed to a great extent to these developments. or margining. In 1865. traded on Chicago Mercantile Exchange. the CBOT went one step further and listed the first "exchange traded" derivatives contract in the US. The primary intention of the CBOT was to provide a centralised location known in advance for buyers and sellers to negotiate forward contracts. Index futures. In 1919.1. The OTC contracts are generally not regulated by a regulatory authority and the exchange's selfregulatory organisation.
5.3 Derivatives markets
Early forward contracts in the US addressed merchants' concerns about ensuring that there were buyers and sellers for commodities.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. which has accompanied the modernisation of commercial and investment banking and globalisation of financial activities. The first stock index futures contract was traded at Kansas City Board of Trade. There are no formal rules or mechanisms for ensuring market stability and integrity. and for safeguarding the collective interests of market participants. The OTC derivatives markets have the following features compared to exchange-traded derivatives:
1. Other popular international exchanges that trade derivatives are LIFFE in England. TIFFE in Japan. leverage. 2. financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. banking supervision and market surveillance. Currently the most popular stock index futures contract in the world is based on S&P 500 index. indeed the two largest "financial" exchanges of any kind in the world today. 3. was reorganised to allow futures trading. During the mid eighties. futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today.
. Chicago Butter and Egg Board. DTB in Germany. a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. Box 1. the former have rigid structures compared to the latter. although they are affected indirectly by national legal systems. SGX in Singapore. However "credit risk" remained a serious problem. Its name was changed to Chicago Mercantile Exchange (CME). The largest OTC derivative market is the interbank foreign exchange market. The CBOT and the CME remain the two largest organised futures exchanges.
The OTC derivatives markets have witnessed rather sharp growth over the last few years. The management of counter-party (credit) risk is decentralised and located within individual institutions. a spin-off of CBOT. 4.
London International Financial Futures and Options Exchange ••
. 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. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Options: There are two types of options . Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset. They can be regarded as portfolios of forward contracts. 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. Thus a swaption is an option on a forward swap. 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. with the cashflows in one direction being in a different currency than those in the opposite direction. • Currency swaps: These entail swapping both principal and interest between the parties. Puts give the buyer the right.
Forwards: As we discussed. the majority of options traded on options exchanges having a maximum maturity of nine months. Chicago Board of Trade 2.16
Introduction to derivatives
1. Some of these.calls and puts. a forward contract is an agreement between two entities to buy or sell the underlying asset at a future date. The underlying asset is usually a weighted average of a basket of assets. Chicago Mercantile Exchange A: The correct answer is number 1. Equity index options are a form of basket options. at a given price on or before a given future date. 3. Baskets: Basket options are options on portfolios of underlying assets.3. 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. Longer-dated options are called warrants and are generally traded over-the-counter. but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. namely futures and options will be discussed in more details at a later stage. at today's pre-agreed price.
Q: Futures trading commenced first on 1. Chicago Board Options Exchange 4.
products 1. Hedging A: The correct answer is number 2. None of the above. Interest rate futures ••
. The buyer and seller agreeing upon a price. Option 2. A: The correct answer is number 1. 2. •• 3. Future A: The correct answer is number 3. 4. There is no formal margining system. All of the ••
2.3 Derivatives markets
Q: Derivatives first emerged as -----. Stock options 4. Over The Counter Exchange of India 4.1. Q: Which of the following exchanges offer commodity derivatives trading 1. Volatility 4. ICICI Securities Limited 3. Q: A ____ is the simplest derivative contract 1. They do not follow any formal rules or mechanisms. 3. Index futures 2. above A: The correct answer is number 4. Index options A: The correct answer is number 1. 4. 3. trading involves ___ 1. The buyer and seller calculating the net out-standing. The buyer and seller exchanging goods and money. Speculative 2. Forward 4. They are not settled on a clearing house. National Commodity Derivatives Exchange 2. Swap •• 3. Interconnected Stock Exchange A: The correct answer is number 1. Q: In a transaction. Q: OTC derivatives are considered risky because 1.
Q: The first exchange traded financial derivative in India commenced with the trading of 1. Risky
Introduction to derivatives
3. The buyer and seller calculating the net outstanding.18
Q: In a transaction. 4. The buyer and seller agreeing upon a price. None of the above. A: The correct answer is number 2. The buyer and seller agreeing upon a price. 2. The buyer and seller calculating the net outstanding. Q: In a transaction. ••
3. The buyer and seller exchanging goods and money. The buyer and seller exchanging goods and money. 4. settlement involves __ 1. 2. clearing involves 1. A: The correct answer is number 3. ••
. None of the above.
Physical settlement involves the physical delivery of the underlying commodity. 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. However in the case of commodities. 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. We have a brief look at these issues. financial assets are not bulky and do not need special facility for storage. Over a period of time. Similarly. typically at an accredited warehouse.
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. Due to the bulky nature of the underlying assets. the quality of the asset underlying a contract can vary largely. However. In India. but the physical
. the concept of varying quality of asset does not really exist as far as financial underlyings are concerned. It is only in the last decade that commodity future exchanges have been actively encouraged.1. In this chapter we look at how commodity derivatives differ from financial derivatives.Chapter 2 Commodity derivatives
Derivatives as a tool for managing risk first originated in the commodities markets. most of these contracts are cash settled.
2. other commodities were permitted to be traded in futures exchanges. This may sound simple. However there are some features which are very peculiar to commodity derivative markets. We also have a brief look at the global commodity markets and the commodity markets that exist in India. physical settlement in commodity derivatives creates the need for warehousing. the markets have been thin with poor liquidity and have not grown to any significant level. Regulatory constraints in 1960s resulted in virtual dismantling of the commodities future markets. Even in the case of physical settlement. This becomes an important issue to be managed. In the case of financial derivatives. They were then found useful as a hedging tool in financial markets as well.
Alternatively. The process of taking physical delivery in commodities is quite different from the process of taking physical delivery in financial assets. in a manner similar to the assignments to a seller in an options market. BMF. 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. 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.
Whenever delivery notices are given by the seller. Typically. There are limits on storage facilities in different states. These are required by virtue of the fact that the actual physical settlement of commodities requires preparation from both delivering and receiving members. Among the international exchanges. Later on we will look into details of how physical settlement happens on the NCDEX. including fiscal debts related to the stored goods. 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.
Delivery notice period
Unlike in the case of equity futures. accept warehouse receipts as quality verification documents while others like BMF-Brazil have independent grading and classification agency to verify the quality. issued by the warehouse. Such contracts are then assigned to a buyer. Besides state level octroi and duties have an impact on the cost of movement of goods across locations. A provisional delivery order of the good to BM&F (Brazil). Some exchanges like LIFFE. In these exchanges the seller has to produce a verification report from these laboratories along with delivery notice. delivery notice is required to be supported by a warehouse receipt. The warehouse receipt is the proof for the quantity and quality of commodities being delivered. both positions can still be closed out before expiry of the contract. in all commodity exchanges. 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. Exchanges follow different practices for the assignment process. A warehouse certificate showing that storage and regular insurance have been paid. 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. CBOT and CME display delivery notices. Exchanges such as COMMEX and the Indian commodities exchanges have adopted this method.
settlement of commodities is a complex process. There are restrictions on interstate movement of commodities. This option is given during a period identified as 'delivery notice period'. We take a general overview at the process flow of physical settlement of commodities. The issues faced in physical settlement are enormous.
After the close of trading. All he has to do is pay up the loss of Rs.2. The discount/ premium for quality and freight costs are published by the clearing house before introduction of the contract. The most active spot market is normally taken as the benchmark for deciding spot prices. if a trader buys futures on a stock at Rs.120. there is a possibility of physical settlement. the futures on that stock close Rs. 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. In some exchanges (CME).20 in cash. In case of most exchange-traded financial derivatives. Alternatively. Buyer or his authorised representative in the presence of seller or his representative takes the physical stocks against the delivery order. The buyer is required to deposit a certain percentage of the contract amount with the clearing house as margin against the warehouse receipt. For instance. 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. The clearing house decides on the daily delivery order rate at which delivery will be settled. Such CWH are required to provide storage facilities for participants in the commodities markets
After the assignment process.100 and on the day of expiration. Assignment is done typically either on random basis or first-in-first out basis. he does not really have to buy the underlying stock.1 Difference between commodity and financial derivatives
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.2 Warehousing
One of the main differences between financial and commodity derivative is the need for warehousing. 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. all the positions are cash settled. the buyer has the option to give his preference for delivery location. exchanges assign the delivery intentions to open long positions. The efficacy of the commodities settlements depends on the warehousing system available. In case of commodity derivatives however. the delivery rate is determined based on the previous day closing rate for the contract or the closing rate for the day. This requires the exchange to make an arrangement with warehouses to handle the settlements. clearing house/ exchange issues a delivery order to the buyer. Similarly the person who sold this futures contract at Rs. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. All he does is take the difference of Rs. the buyer must take physical delivery of the underlying asset. Cash settlement involves paying up the difference in prices between the time the contract was entered into and the time the contract was closed.20 in cash.1. The exchange also informs the respective warehouse about the identity of the buyer. Which means that if the seller chooses to hand over the commodity instead of the difference in cash. does not have to deliver the underlying stock.
In India. Central and state government controlled warehouses are the major providers of agri-produce storage facilities. lodgepole pine. which specify standards for export oriented commodities.
2. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing. Currently there are various agencies that are responsible for specifying grades for commodities. Standard and Better. Englemann spruce. Montana.
2.1. Table 2. A good grading system allows commodities to be traded by specification.2 Global commodities derivatives exchanges
Globally commodities derivatives exchanges have existed for a long time. Nevada. The CBOT and CME are two of the oldest derivatives
. it is therefore important that the exchange stipulate the grade or grades of the commodity that are acceptable.1 gives a list of commodities exchanges across the world. the quality of the underlying asset is of prime importance. The Chicago Mercantile Exchange in its random-length lumber futures contract has specified that "Each delivery unit shall consist of nominal 'i y. The advantage of this system is that a warehouse receipt becomes a good collateral.3 Quality of underlying assets
A derivatives contract is written on a given underlying. the warehousing system is not as efficient as it is in some of the other developed markets.is of random lengths from 8 feet to 20 feet.22
The New York Cotton Exchange has specified the asset in its orange juice futures contract as "U. Wyoming. Apart from these. in no case may the quantity of Standard grade or #2 exceed 50%.S Grade A. with factors of color and flavour each scoring 37 points or higher and 19 for defects. Idaho. there are a few private warehousing being maintained. 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. however. Each deliver unit shall be manufactured in California. There may be quite some variation in the quality of what is available in the marketplace. Apart from these.3: Specifications of some commodities underlying derivatives contracts
and to certify the quantity and quality of the underlying commodity. When the underlying asset is a commodity. or #1 and #2. For example. When the asset is specified. hem-fir. grade-stamped Construction Standard. not just for settlement of exchange trades but also for other purposes too. and/ or spruce pine fir". with Brix value of not less than 57 degrees. Washington. or Alberta or British Columbia. there are other agencies like EIA. However there is no clear regulatory oversight of warehousing services. with a minimum score 94". Box 2. having a Brix value to acid ratio of not less than 13 to 1 nor more than 19 to 1. Commodity derivatives demand good standards and quality assurance/ certification procedures. Oregon. and contain lumber produced from grade-stamped Alpine fir. Canada.
In 1919. Now futures exchanges exist all over the world. a wide range of commodities and financial assets form the underlying assets in
.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. On these exchanges. It was know as the to-arrive contract. Within a few years the first futures-type contract was developed. Speculators soon became interested in the contract and found trading in the contract to be an attractive alternative to trading the underlying grain itself. The CBOT was established in 1848 to bring farmers and merchants together. 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
exchanges in the world. another exchange. the CME was established.2.2 Global Commodities derivatives exchanges Table 2. 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. Singapore Singapore Commodity Exchange Ltd. Initially its main task was to standardise the quantities and qualities of the grains that were traded. France Le Nouveau Marche MATIF Italy Italian Derivatives Market Netherlands Amsterdam Exchanges Option Traders Russia The Russian Exchange MICEX/ Relis Online St.
namely. The commodities include pork bellies.2. Mexico has only recently introduced a futures exchange to its markets. bread milling wheat and sunflower seeds. Singapore is home to the Singapore Exchange (SGX). The main commodities traded were agricultural staples such as wheat. We look at commodity exchanges in some developing countries. was the first organised futures market. SAFEX only traded financial futures and gold futures for a long time. more than half of China's exchanges were closed down or reverted to being wholesale markets.2 Asia
China's first commodity exchange was established in 1990 and at least forty had appeared by 1993.3 Latin America
Latin America's largest commodity exchange is the Bolsa de Mercadorias & Futures. corn and in particularly soybeans. the Agricultural Derivatives Division) led to the introduction of a range of agricultural futures contracts for commodities. Although this exchange was only created in 1985. in which trade was liberalised. ranks as the world's 51st largest exchange. was established in 1893 following the widespread discontent
.. Cereals & Oils Exchanges.
Africa's most active and important commodity exchange is the South African Futures Exchange (SAFEX). lumber. gold and tin. formed in 1999 after the merger of three exchanges: Shanghai Metal. spread throughout the country. Bombay Cotton Exchange Ltd.2. copper.
2. it was the 8th largest exchange by 2001. (BM&F) in Brazil. wool. live cattle. Commodity. The Taiwan Futures Exchange was launched in 1998. the Dalian Commodity Exchange (DCE).
2. The Mercado Mexicano de Derivados (Mexder) was launched in 1998. sugar. the Stock Exchange of Singapore (SES) and Singapore International Monetary Exchange (SIMEX). which was formed in 1999 by the merger of two well-established exchanges. At the beginning of 1999. In late 1994. Malaysia hosts one futures and options exchange.3 Evolution of the commodity market in India
Bombay Cotton Trade Association Ltd. while only 15 restructured exchanges received formal government approval. It was informally launched in 1987. the China Securities Regulatory Committee began a nationwide consolidation process which resulted in three commodity exchanges emerging. There are also many other commodity exchanges operating in Brazil. aluminium. but the creation of the Agricultural Markets Division (as of 2002. white and yellow maize. Malaysia and Singapore have active commodity futures exchanges. the Zhengzhou Commodity Exchange and the Shanghai futures Exchange.24
various contracts. set up in 1875. Argentina's futures market Mercado a Termino de Buenos Aires.
2. with 98 million contracts traded. founded in 1909.
6. Futures trading in bullion began in Mumbai in 1920. Kabra. To assess the role that forward trading can play in marketing/ distribution system in the commodities
in which forward trading is possible.
2. to conduct organised trading in both Raw Jute and Jute goods. particularly with a view to effective enforcement of the Act to check illegal forward trading when such trading is prohibited under the Act.N. 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. 4. But organised futures trading in raw jute began only in 1927 with the establishment of East Indian Jute Association Ltd. 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. The Futures trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali.3. K. In due course.2. was established in 1919 for futures trading in rawjute and jute goods. 3. To examine the extent to which forward trading has special role to play in promoting exports. which carried on futures trading in groundnut. Calcutta Hessian Exchange Ltd. 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. several other exchanges were created in the country to trade in diverse commodities. 2. To suggest amendments to the Forward Contracts (Regulation) Act. particularly in commodities in which resumption of forward trading is generally demanded. 5.3 Evolution of the commodity market in India
amongst leading cotton mill owners and merchants over functioning of Bombay Cotton Trade Association. To review the role that forward trading has played in the Indian commodity markets during the last 10 years. castor seed and cotton. Futures trading in wheat was existent at several places in Punjab and Uttar Pradesh. the Government of India appointed in June 1993 a committee on Forward Markets under chairmanship of Prof.
. The committee was setup with the following objectives:
1. But the most notable futures exchange for wheat was chamber of commerce at Hapur set up in 1913. These two associations amalgamated in 1945 to form the East India Jute & Hessian Ltd.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. in the light of the recommendations.
• The FMC which regulates forward/ futures trading in the country. 1952. Rice bran oil 6. • The majority of me committee recommended that futures trading be introduced in the following commodities: 1. should continue to act a watch-dog and continue to monitor the activities and operations of the commodity exchanges.2003 permitting futures trading in the commodities. Options trading in commodity is. Therefore. sesame seed.4. Enlisting more members. Raw jute and jute goods 4. cottonseed. Groundnut. some of the commodity exchanges.
. Basmatirice 2. 5. with the issue of these notifications futures trading is not prohibited in any commodity. • In the context of globalisation. ensuring capital adequacy norms and encouraging computerisation would enable these exchanges to place themselves on a better footing. Silver
9. Castor oil and its oilcake 7. commodity markets in India could not function effectively in an isolated manner. safflower seed. 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. • Due to the inadequate infrastructural facilities such as space and telecommunication facilities the commodities exchanges were not able to function effectively.26
The committee submitted its report in September 1994. 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. Amendments to the rules. sunflower seed. would need to be strengthened. Cotton and kapas 3. The recommendations of the committee were as follows:
• The Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act. the government issued notifications on 1. Linseed 8. rapeseed/mustard seed. As a follow up. be upgraded to the level of international futures markets. particularly the ones dealing in pepper and castor seed. however presently prohibited. copra and soybean. • In-built devices in commodity exchanges such as the vigilance committee and the panels of surveyors and arbitrators be strengthened further. regulations and bye-laws of the commodity exchanges should require the approval of the FMC only. and oils and oilcakes of all of them.
National level commodity derivatives exchanges seem to be the new phenomenon.
• National Board of Trade • Multi Commodity Exchange of India
• National Commodity & Derivatives Exchange of India Ltd
. Table 2. the commodity derivative market in India seems poised for a transformation. today. Muzzaffarnagar Rajkot seeds. Table 2. annual vol (Rs.2 Latest developments
Commodity markets have existed in India for a long time. Ahmedabad Ahmedabad commodity exchange Rajdhani Oil & oilseeds Vijai Beopar Chamber Ltd.Crore) 80000 40000 3500 3500 2500 2500 2500 2500 1500 1500 140000
2.2 Volume on existing exchanges Commodity exchange National board of trade.2. Hapur Bhatinda Om and oil exchange Other (mostly inactive) Total Products Soya. groundnut Pepper Gur. The increasing volumes on these exchanges suggest that commodity markets in India seem to be a promising game. cotton Mustard Gur Castor. Indore National multicommodity exchange. The Forward Markets Commission accorded in principle approval for the following national level multi commodity exchanges. oil & bullion exchange IPSTA. While the implementation of the Kabra committee recommendations were rather slow.3 gives the list of registered commodities exchanges in India. mustard Multiple Castor.3.3 Evolution of the commodity market in India Table 2. mustard Gur
27 Approx.2 gives the total annualised volumes on various exchanges. Cochin Chamber of commerce.
Copra Rapeseed/ Mustardseed. Coconut oil & Copra cake The Coffee Futures Exchange India Ltd. RBD Pamohen Limited. Silver
. rice bran oil and oilcake Crude palm oil The Rajkot Seeds oil & Bullion Merchants Groundnut oil Association. Bangalore Coffee National Multi Commodity Exchange of India Gur. tin Vanaspati. oil. gram Coconut (oil and oilcake) Castor (oil and oilcake) Sesamum (Seed. Soy bean Cotton (Seed. oil.
Gur Sunflower oil Cotton (Seed and oil) Safflower (Seed.Sangli Turmeric Ahmedabad Commodities Exchange Ltd. oil and oil cake) Groundnut (Nut and oil) Castor oil. Castorseed Sesamum (Oil and oilcake) Rice bran. Hessian. Kochi Pepper Rajdhani Oils and Oilseeds Exchange Ltd. oilcake) Safflower (seed.oil and oilcake) Linseed (seed. Gur The Spices and Oilseeds Exchange Ltd. Gur The East India Jute & Hessian Exchange Ltd. Sacking. oilcake) Groundnut (seed. Ltd. Copper. Hapur Gur. Guarseed Aluminium ingots. Zinc. Castorseed The Kanpur Commodity Exchange Ltd. Ltd. The Bombay Commodity Exchange Ltd. oil and oilcake) Rice Bran Oil. Refined Soy Oil Limited Mustard Seed Expeller Mustard Oil RBD Palmolein Crude Palm Oil Medium Staple Cotton Long Staple Cotton Gold. Delhi Gur. Mumbai Cotton The Central India Commercial Exchange Ltd..3 Registered commodity exchanges in India Exchange Bhatinda Om & Oil Exchange Ltd. Castorseed Vijay Beopar Chamber Ltd. Rubber. Crude Palm Oil The Chamber of Commerce. lead National Commodity & Derivatives Exchange Soy Bean.. Pepper. Cottonseed... Nickel. Kochi Copra. Rapeseed/ Mustardseed The East India Cotton Association. Rapeseed/ Mustardseed oil and cake The Meerut Agro Commodities Exchange Co.. Ahmedabad Crude Palm Oil. Rapeseed/ Mustardseed Sugar Grade-M National Board of Trade. oil.28 Table 2. oilcake) Sugar. Muzaffarnagar Gur India Pepper & Spice Trade Association.. Indore Rapeseed/ Mustard seed/ Oil/ Cake Soybean/ Meal/ Oil. Sacking Kolkata First Commodity Exchange of India Ltd.
3. • Q: Which of the following exchanges do not offer commodity derivatives trading? 1. The seller •
. Letter of credit 2.3 Evolution of the commodity market in India
Q: Which of the following feature differentiates a commodity futures contract from a financial futures contract? 1. National Commodity Derivative Exchange 2. The clearing corporation A: The correct answer is number 2. National Board of Trade 4. Exchange traded product 2. Standardised contract size A: The correct answer is number 4. Warehouse receipt A: The correct answer is number 2.2. • 3. Undertaking 4. National Stock Exchange •• 3. Multi Commodity Exchange of India A: The correct answer is number 4. None of the above •
Q: Typically. Advance payment •
Q: Who identifies the buyer to whom the delivery notice is assigned? 1. an accredited warehouse 2. delivery notice is required to be supported by a 1. • 3. Varying quality of underlying asset •
Q: Physical settlement involves the physical delivery of the underlying commodity at 1. The exchange 2. in all commodity exchanges. MTM settlement 4. The warehouse 4. the exchange A: The correct answer is number 1 • 3. the buyers requested destination 4.
30 Q: On the NCDEX ___ 1. need to be strengthened. The seller assigns delivery to the buyer A: The correct answer is number 1. 1. The warehouse assigns the delivery to the buyer ••
Q: The ____ committee recommended that the Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act. J R Varma Committee ••
. The clearing house assigns delivery to the buyer 2. Kabra Committee A: The correct answer is number 2. Khusro Committee 4. 3. L C Gupta Committee 2. 1952.
3. The buyer chooses which delivery to take 4.
• To bring together the entities that the market can trust. Besides.
3. • To provide nation wide reach and consistent offering. NCDEX currently facilitates trading of ten commodities . expeller rapeseed-mustard seed oil. At subsequent phases trading in more commodities would be facilitated. technology platforms. refined soy bean oil. low cost solutions and information dissemination without noise etc.gold. It is located in Mumbai and offers facilities to its members in about 91 cities throughout India at the moment. silver. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. RBD palmolein. soy bean. Contracts 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. NCDEX is subjected to various laws of the land like the Companies Act.
.Chapter 3 The NCDEX platform
National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. It is a public limited company registered under the Companies Act. rapeseed-mustard seed.2003. Forward Commission (Regulation) Act and various other legislations. NCDEX is regulated by Forward Markets Commission in respect of futures trading in commodities. 1956 with the Registrar of Companies. • To bring professionalism and transparency into commodity trading.1
Structure of NCDEX
NCDEX has been formed with the following objectives:
• To create a world class commodity exchange platform for the market participants. into the trade. which impinge on its working.medium and long staple varieties. • To inculcate best international practices like de-modularization. crude palm oil and cotton . Maharashtra in Mumbai on April 23. professionalism and transparency. Stamp Act.
The members of NCDEX fall into two categories. Trading cum Clearing Members (TCM) and Professional Clearing Members (PCM).
3.1. Life Insurance Corporation of India (LIC).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. These include the ICICI Bank Limited (ICICI Bank). The TCM membership entitles the members to trade and clear. The directors are appointed in accordance with the provisions of the Articles of Association of the company. trust. companies etc. partnerships. The board is responsible for managing and regulating all the operations of the exchange and commodities transactions. technology and risk management skills.1. Applicants accepted for admission as TCM are required to pay the required fees/ deposits and also maintain net worth as given in Table 3. It formulates the rules and regulations related to the operations of the exchange. Promoters do not participate in the day to day activities of the exchange. Risk Committee.1. and also other members appointed by the board. nationwide reach. The four institutional promoters of NCDEX are prominent players in their respective fields and bring with them institution building experience. co-operative societies. that fulfills the eligibility criteria set by the exchange. Nomination Committee. both for themselves and/ or on behalf of their clients.2. help the Board in policy formulation.2 Governance
NCDEX is run by an independent Board of Directors. Apart from the executive committee the board has constitute committee like Membership committee. The executive committee consists of Managing Director of the exchange who would be acting as the Chief Executive of the exchange.2 Exchange membership
Membership of NCDEX is open to any person. NCDEX is the only commodity exchange in the country promoted by national level institutions. This unique parentage enables it to offer a variety of benefits which are currently in short supply in the commodity markets.
3. Compensation Committee and Business Strategy Committee. which. Audit Committee.1 Promoters
NCDEX is promoted by a consortium of institutions.
. All the members of the exchange have to register themselves with the competent authority before commencing their operations. National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE). Board appoints an executive committee and other committees for the purpose of managing activities of the exchange.
3. association of persons.32 ___________________________________________________ The NCDEX platform
Table 3. Applicants accepted for admission as PCMs are required to pay the following fee/ deposits and also maintain net worth as given in Table 3.50 50.1 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. the member has to deposit Base Minimum Capital (BMC) with the exchange.00 5000. Base Minimum Capital comprises of the following:
1.00 1.00 15. Collateral security deposit
All Members have to comply with the security deposit requirement before the activation of their trading terminal.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.3 Capital requirements
NCDEX has specified capital requirements for its members.3 Capital requirements Table 3.00 25.50 0. both for themselves and/ or on behalf of their clients.2. On approval as a member of NCDEX. Interest free cash security deposit 2.2 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.
.3.00 0. The PCM membership entitles the members to clear trades executed through Trading cum Clearing Members (TCMs).2.00 1.
3. 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.
the trading facility would be withdrawn with immediate effect. time and quantity.4 The NCDEX system
As we saw in the first chapter.trading. It tries to find a match on the other side of the book. 5 Lakh. it is an active order.4.00 a. to 4. • Fixed deposit receipt: Fixed deposit receipts (FDRs) issued by approved banks are accepted.15 Lakh in case of TCM and Rs. The NCDEX system supports an order driven market. 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.e. clearing and settlement.
3. The FDR should be issued for a minimum period of 36 months from any of the approved banks. a trade is generated. It supports an order driven market and provides complete transparency of trading operations. the order becomes passive and gets
. The trade timings of the NCDEX are 10. The exchange notifies the regular lot size and tick size for each of the contracts traded from time to time. The exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities .
3. where orders match automatically. After hours trading has also been proposed for implementation at a later stage. When any order enters the trading system.00 p. fixed deposit receipts or Government of India securities.34
The NCDEX platform
• Bank guarantee: Bank guarantee in favour of NCDEX as per the specified format from approved banks. If it finds a match.1
The trading system on the NCDEX. Rs. The securities are valued on a daily basis and a haircut of 25% is levied.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. The minimum term of the bank guarantee should be 12 months. This section provides a brief overview of how transactions happen on the NCDEX's market.
• Government of India securities: National Securities Clearing Corporation Limited (NSCCL) is the
approved custodian for acceptance of Government of India securities.
Members who wish to increase their limit can do so by bringing in additional capital in the form of cash.m. bank guarantee. All quantity fields are in units and price in rupees.
Members are required to maintain minimum level of security deposit i.m. Order matching is essentially on the basis of commodity.
• If the security deposit shortage is less than Rs. every market transaction consists of three components . 25 Lakh in case of PCM at any point of time. If the security deposit falls below the minimum required level. provides a fully automated screen-based trading for futures on commodities on a nationwide basis as well as an online monitoring and surveillance mechanism. its price. If it does not find a match.
A professional clearing member is responsible for settling all the participants trades which he has confirmed to the exchange.3 Settlement
Futures contracts have two types of settlements.4 The NCDEX system_________________________________________________ 35
queued in the respective outstanding order book in the system.
3. NCDEX trades commodity futures contracts having one-month. The seller intending to make delivery takes the commodities to the designated warehouse. The cash settlement is only for the incremental gain/ loss as determined on the basis of final settlement price. If the 20th of the expiry month is a trading holiday. The commodities have to meet the contract specifications with allowed variances.3.4. on the basis of locations and then randomly.2 Clearing
National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX. Unmatched positions have to be settled in cash. keeping in view the factors such as available capacity of the vault/ warehouse. The responsibility of settlement is on a trading cum clearing member for all trades done on his own account and his client's trades. the matching for deliveries takes place firstly. matches the information and arrives at a delivery position for a member for a commodity. two-month and three-month expiry cycles. created during the day or closed out during the day. 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. All contracts expire on the 20th of the expiry month. are market to market at the daily settlement price or the final settlement price at the close of trading hours on a day. NCDEX on receipt of such information. after the trading hours on the expiry date. clearing members are informed of the deliverable/ receivable positions and the unmatched positions. These commodities have to be assayed by the exchange specified assayer. Matching done by this process is binding on the clearing members. either brought forward. and the final settlement which happens on the last trading day of the futures contract. At NCDEX. On the expiry date of a futures contract. If the commodities meet the
. based on the available information.4. 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. The settlement guarantee fund is maintained and managed by NCDEX. the final settlement price is the spot price on the expiry day. After completion of the matching process. Only clearing members including professional clearing members (PCMs) only are entitled to clear and settle contracts through the clearing house. All positions of a CM. 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. commodities already deposited and dematerialized and offered for delivery etc.
3. New contracts will be introduced on the trading day following the expiry of the near month contract. On the date of expiry. On the NCDEX. the contracts shall expire on the previous trading day. the MTM settlement which happens on a continuous basis at the end of each day. Time stamping is done for each trade and provides the possibility for a complete audit trail if required.
the warehouse accepts them. Warehouse then ensures that the receipts get updated in the depository system giving a credit in the depositor's electronic account.5000Lakh •• 3. Q: The net worth requirement for a TCM is 1.50Lakh A: The correct answer is number 2. Reserve Bank of India 4. Rs. On an appointed date.
Q: Which of the following futures do not trade on the NCDEX? 1. Gold futures A: The correct answer is number 4. The Forward Markets Commission 2. Energy futures ••
. Cotton futures 2.5Lakh 2. Rs. Rs. SEBI A: The correct answer is number 1. Q: NCDEX is regulated by 1. who would courier the same to the buyer's clearing member. Rs. The seller then gives the invoice to his clearing member.500Lakh 4.36 ________________________________________________________ The NCDEX platform specifications. the buyer goes to the warehouse and takes physical possession of the commodities. Silver futures 4. Controller of Capital Issues •• 3. 3.
cotton. Energy Of these. clearing and settlement details will be discussed later. crude palm oil and RBD palmolein are being offered.Chapter 4 Commodities traded on the NCDEX platform
In December 2003. the contract size stating exactly how much of the asset will be delivered under one contract. Other metals
4. The commodity markets can be classified as markets trading the following types of commodities. the exchange must specify the exact nature of the agreement between two parties who trade in the contract. We have a brief look at the various commodities that trade on the NCDEX and look at some commodity specific issues. it must specify the underlying asset. To begin with contracts in gold. medium staple cotton and long staple cotton. silver. rape/ mustard seed. For derivatives with a commodity as the underlying. Precious metal 3. Of these we study cotton in detail and have a quick look at the others. crude palm oil. rapeseed oil. Trading. RBD palmolein.
1. Agricultural products 2. the NCDEX has commenced trading in futures on agricultural products and precious metals.Refined soy oil. expeller mustard oil.
4. where and when the delivery will be made. the National Commodity and Derivatives Exchange Ltd (NCDEX) launched futures trading in nine major commodities.
The NCDEX offers futures trading in the following agricultural commodities . In particular. soya oil. In this chapter we look at the various underlying assets for the futures contracts traded on the NCDEX. mustard seed.
During the period of fruiting. 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. a minimum temperature of 150°C is required. a favourable distribution is the deciding factor in obtaining good yields from the rainfed cotton.
. 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. It is grown mainly as a dry crop in the black and medium black soils and as an irrigated crop in the alluvial soils.38
Commodities traded on the NCDEX platform
4. a rainfall of 50 cm is the minimum requirement. Spinned cotton yarn is used by clothe manufacturers/ textile industry. and (4)Lateritic soils .5% during the last three years. The optimum temperature range for vegetative growth is 21.270°CIt can tolerate temperatures as high as 430°C . Kappas are bought by ginners. the crop is sown during the June-July period and harvested during September-October. apart from other fibre sources like jute. which predominates and occupies nearly 75% of the area under this crop. Andhra Pradesh. warm days and cool nights. both from agricultural and manufacturing sectors' points of view. It occupies a significant position.1
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). Rajasthan and Uttar Pradesh. 1 bale = 170 kg) of raw cotton trade in the country. over 17 million bales (average annual consumption.predominant in the states of Gujarat. Harvested Kappas (cotton with seed) start arriving into the market (from the producing centres) from October-November onwards. in USA. The market size of raw cotton in India is over Rs. Cotton is among the most important non-food crops. but does not do well if the temperature falls bellow 210°C. (3)The red sandy loams to loams . Historically. cotton prices in India have been fluctuating in the range of 3-6% on a monthly basis. Karnataka and Tamil Nadu.found in parts of Tamil Nadu.
Cropping and Growth pattern
Cotton is a tropical and sub-tropical crop. Haryana. Cotton is grown on a variety of soils. Madhya Pradesh.1. In the main producing countries of USA. Assam and Kerala. More than the actual rainfall.45/ kg. It requires a soil amenable to good drainage. The predominant types of soils on which the crop is grown are (l)Alluvial soils predominant in the northern states of Punjab. For the successful germination of its seeds. It is the major source of a basic human need clothing. India and Pakistan. The average monthly fluctuation in prices of cotton traded across India has been at around 4. Today. The maximum fluctuation has been as high as 11%. Maharashtra. as it does not tolerate water logging. it is 480 pounds). 27-30% of the country's export earnings and 4% of its GDP. a process called ginning (lint recovery from kappas is 30-31%). silk and synthetic. China. In the case of the rain-fed cotton. At the average price of Rs.130 billion. 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. (2)The black cotton soils. who separate the seeds from the lint (cotton fibre). with large diurnal variations are conducive to good boll and fibre development. Cotton is a 90-120 day annual crop.
These along with Turkey. Mexico. and the CIS countries and Australia on account of lower freight and shorter delivery periods. India is also importing from Egypt. India and Pakistan top the list of cotton producing countries. The central government establishes minimum support prices (MSP) for Kappas at the start of each marketing season. These eight countries produced over 80% of the world's cotton production during 2001-02. between 2. Currently. Thailand.e. 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. 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). Italy and Korea consume over 80% of the world's annual cotton consumption. production and prices of synthetic fibre (polyester. constituting about 15% of the global cotton production.e. The global export and import trade of cotton during the post 1990 era has been in the range of 5.6 million bales during the pre-1996 period have dipped to less than 100 thousand bales. Contrary to this. 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. Similarly.8 million tons). The CCI is responsible for establishing the price support in all States.5-21 million tons.5 million tons.1 Agricultural commodities Global and domestic demand-supply dynamics
China. the country's cotton consumption stands at 17-19 million bales (2. West Africa. Mills using ELS (extra long staple) have been pleased with US Pima and its fibre characteristics. Cotton trade is influenced by the supply-demand scenario.2 million bales during the last three years. India.
Price trends and factors that influence prices
Cotton production and trade is influenced by various factors. USA and Pakistan top the list of cotton consuming countries. Apart from US. Production of cotton in India during the post 1990 period has been fluctuating in the range of 1217 million bales (i. Brazil.4. Global production of cotton during the post 1990 (till date i. market prices remain well above the MSP. 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. US has emerged as an important supplier in the last two seasons.7-2. higher ginning out-turn) and better credit terms (36 months vs. Brazil. Russia. uniform lots.9 million tons). India's position on the global trade front has witnessed a drastic change during the post 1995 period. Indonesia. viscose and acrylic) and prices of cotton itself. Most importing mills in India are ready to pay 5-10% premium for foreign cotton due to its higher quality (less trash. China. USA. Uzbekistan. Turkey and Australia are the other major producers. 2002-03 forecast) has been fluctuating in the narrow range of 16.5 to 6.2-2. etc. The country has turned from being net exporter to net importer. consumption has been in the range in the 18-20. the imports have sharply risen from 30000-50000 bales during the pre-1995 to little over 2. 15-30 days for local). Among several other reasons. Typically.
. The country's raw cotton exports. which stood at 1.2-1.5 million tons.
The average monthly fluctuation in prices of imported CPO traded at Kandla (one of the major importing ports in Gujarat) has been at 9.
4. are less likely to have any major impact on cotton prices in India. RBD (refined. which is used both for edible and industrial purposes). The country is over-dependent on CPO imports to the extent of over 50% of its annual vegetable oil imports.37% compounded annually during the last 12 years period. Cotton prices in India are therefore influenced by various demand-supply factors operating within the country. well structured and well drained. Flat or gentle undulating land is preferred.2 Crude palm oil
Annual edible oil trade in India is worth over Rs. The consumption of palm oil (both food and industrial consumption put together) in the world is growing at the rate of 7. the consumption growth rate for the worlds leading palm oil importer
. with the share of CPO being nearly 20% (Rs. the consumption of palm oil is growing at the rate of 5. Towards mid-2002. While in the importing countries like China and European Union. 2001). Crude palm oil (CPO).20 US Cents/ lb (as on Oct 26. Oil palm can be grown on a wide range of soil. 2001) to the low of 28. crude palmolein.80-90 billion). which when crushed yields 6 tons of oil (including the kernel oil. etc.35%. wool and khadi . in areas where rainfall is marginally suitable. NyBOT witnessing a sharp downfall in prices from 61. Oil palm thrives well at temperatures of 22 .the other fibre sources. There is a close inter linkage between the various vegetable oils produced. demand for finished readymade garments from abroad. In general. RBD palmolein and crude palm kernel oil (CPKO) are the various forms of palm oil traded in the market. prices recovered to 53 cents. and toward end of 2003 were currently ruling at 58. Rainfall less than 100 mm for a period of more than three months is not suitable for oil palm cultivation. Jute.440 billion. the maximum monthly fluctuation being as high as 25% during the period. international raw cotton prices. the soil should be deep. deodorized) palm oil. a sharp fall by 54.40
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. silk.5 and stagnant water.8% respectively.7% during the past two and a half years. traded and consumed across the world. World cotton prices fell sharply during most part of 2001.
Cropping and growth patterns
Oil palm requires an average annual rainfall of 2000 mm or more distributed evenly throughout the year. One hectare of oil palm yields approximately 20 FFBs. the waterholding capacity of the soil is of greatest importance.85 cents.2% and 4.
Global and domestic demand-supply dynamics
CPO is used for human consumption as well as for industrial purposes.33°C with at least 5 hours sunshine per day throughout the year.78 US Cents/ lb (as on Jan 2.1. Palm oil is extracted from the mature fresh fruit bunches (FFBs) of oil palm plantations. However. Oil palm is sensitive to pH above 7. prices of synthetic fibre. bleached.
canola/ rapeseed. China. This exchange trades only CPO among several derivatives of palm. large refiners. Kakinada. etc.
Price trends and factors that influence prices
There exists a clear trough and crest in the seasonality of CPO production. Pakistan and the European Union are the major importers of palm oil. supply-demand scenario of palm and its competing soy oil in the global market apart from other vegetable oil sources viz. etc. The Kuala Lumpur based Malaysia Derivatives Exchange Bhd. The total imports of India. India. production and trade policies of the Government. India. Their share in the global exports of CPO is to the tune of 90%. Yield levels of the plantations are influenced by climatic conditions like rainfall. Rising consumption of palm oil in India.4. Production is almost evenly distributed throughout the year between 0. The domestic production of palm oil forms almost a negligible part of the total edible oil consumption in the country. coconut oil. 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. Production of palm oil stands at 24-25 million tons (over 22% of the global vegetable oil). temperature. acreage under palm plantation does not vary from season to season. China. However. indicating a typical seasonality in the production cycle. The major importing and trading centres for palm in India are Chennai. The industry is dominated by over 200 importing companies. India is the largest importer of CPO with a share of over 15% of the total quantity traded in the international market. sunflower. which could be mainly attributed to its price competitiveness among several of its competing oils is being met through increasing imports. Being a perennial plantation crop.1 Agricultural commodities
(in specific. etc. Kolkata.1 million tons in a monthly. 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.. The entire industry of CPO in India is dominated by importers. who are mostly refiners too. The major trading centres of CPO in the world are Malaysia and Indonesia in Asia and Rotterdam in Europe. Palm oil supports many other industries in India like refining. market and policy related factors. March and April. processors. vanaspati and other industrial sectors apart from human consumption as RBD palmolein. The two producing countries viz. The production bottoms down in the months of February. corporate involved in wholesale and retail trade through value-addition and retail-regional level players along with a few national level players. while the it is at its peak during the months of August.8-1. but next to the four major trading centers. stands at 25%. commodity-specific producers and traders. it exhibits seasonal highs and lows once in a year. Factors that influence price are market related factors viz. Palm oil trade is influenced by various production. Mangalore and Karwar also play important role. Malaysia and Indonesia dominate the global trade in CPO. September and October. supply-demand status of various consuming/importing countries. groundnut. solvent extractors. overall health of the economy that has a bearing on the purchasing power of ultimate consumers. Palm oil dominates the global vegetable oil export trade. and edible oils in general). Domestic oilseed and edible oil industry is organised in the form of oilseed crushers. Mumbai and Kandla. The other centers like Mundra. mainly the exportimport policy. technologists.
which is one of the largest importer and consumer of edible oils in the world. Mangalore. solid at room temperature). Olein is relatively unstable (unsaturated fat. The import is mainly through the ports of Kandla.
Trade policies in India
Since oilseed is one among the major crops cultivated by millions of farmers spread across the country. While Oil is a stable derivative saturated fat. The domestic production of palm oil forms almost a negligible part of the total edible oil consumption in the country. and is the major source of cooking oil to over one billion consuming populace of the country. Fractionation of RBD palm oil yields RBD palmolein along with stearin. current and a short-term forecast of the future status of the industry in various producing and consuming countries. Mundra. the duty structure on various forms of palm oil is the major trade-related protectionist measure. While the strategy of farm subsidies and minimum support price (MSP) are on the production side. There has been a sharp rise in the imports of palm oil into the country during the post 1998 period. Its production grew from 5000 tons in 1991 to 35. followed by Indonesia). 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. Mumbai and Chennai. Kakinada.5 million tons in 2002.
4.1. RBD palmolein exports from Malaysia have increased from 3. which is a white solid at room temperature.
. imports nearly 3 million tons of palm oil annually (mainly from Malaysia.42
Commodities traded on the NCDEX platform
over-all status of the edible oil industry during the immediate past. 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.3 RBD Palmolein
The RBD (refined. The whole quantity of CPO that is produced and used for human consumption is in the form of RBD palmolein. Cropping of growth patterns of CPO has been already covered. Pakistan and Middle-East countries are the major importers of RBD palmolein.2 million tons in 1998 to 4. Kolkata. which supply palm oil to the world to the extent of over 85% of the annual global trade in palm oil. At the same time. Government of India (Gol) adopts a protection policy with regard to production and trade in vegetable oils. like any other welfare state. India. RBD palm oil and fatty acids are obtained. so as to protect the interests of both the producers and consumers. but low cholesterol). This implies that the country is dependent on palm oil imports for over 25% of its annual edible oil consumption.
Global and domestic demand-supply dynamics
The European Union. When CPO is subjected to refinement. export largely as CPO as is demanded by the importing nations who refine domestically and consume.000 tons in 2002. Malaysia and Indonesia. liquid at room temperature. bleached and deodorized) palmolein is the derivative of crude palm oil (CPO). which is obtained from the crushing of fresh-fruit-bunches (FFBs) harvested from oil palm plantations.
which is often subjected to various production and marketrelated uncertainties. Rising consumption of palm oil in India could be mainly attributed to the price sensitive nature of the Indian edible oil consumers. soy oil prices traded across the world are highly volatile in nature. The crop.6% during the past two and a half years. RBD palmolein prices are influenced by CPO prices and the domestic consumer demand for various edible oils at a given point of time. 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. overall health of the economy that has a bearing on the purchasing power of ultimate consumers. which is ready for harvest by the end of September. whose sowing begins by end-June with the arrival of southwest monsoon. production and trade policies of the Government mainly the exportimport policy.5-8.1. While the oil is mainly used for human consumption. 18% oil and 78-80% meal is obtained. Palm and soy oils together constitute around 68% of global edible oil export trade volume. soy oil prices in the major spot markets across the country have been fluctuating in the range of 4. Of the annual edible oil trade worth over Rs. 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.4. with soy oil constituting 22. next only to palm.90-92 billion in terms of value. Unlike the price of CPO imported into the country.4 Soy oil
Soy oil is among the major sources of edible oils in India.440 billion in the country. which could use soy oil futures contract as the most effective hedging tool to minimise price risk in the market. It accounts for nearly 25% of the world's total oils and fats production. starts
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. Increasing price competitiveness.254 million tons in 1990 to nearly 3 million tons during 2001-02. soy oils share is over 20-21% at Rs.85%. On crushing mature beans. etc.
Cropping and growth patterns
In India. the maximum monthly fluctuation being as high as 17% during the period.1 Agricultural commodities
while the consumption of palm in India grew from 0. The average fluctuation in spot prices of refined soy oil traded at Mumbai has been at 6. which is largely dependent on price of CPO traded at Malaysia and the importers and stockiest/ traders demand in India. growing at the rate of 25% compounded annually during the past decade. Soy oil is the derivative of soybean. Historically. Soy oil is the leading vegetable oil traded in the international markets. Being an agricultural commodity. prices of various domestically produced and imported oils. soybean is purely a Kharif crop. meal serves as the main source of protein in animal feeds.5%.
1 million tons of production.38 million tons. Ujjain. production and trade policies of the government . United States is the major producer of soy oil in the world. 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. growing at the rate of 2.90 billion. Russia.8 million tons of imports take the country's annual soy oil consumption to 2. While the Indore price reflects the domestically crushed soybean oil (refined and solvent extracted).9% respectively. slightly higher than the growth rate of its production (2.7 million tons. growing at the rate of 5%.5-1. Notable upward movement in consumption of soy oil is being seen in EU.7-0.44
Commodities traded on the NCDEX platform
entering the market from October beginning onwards. It has been growing at the rate of 5. Its
.95%. Mexico. over-all health of the economy that has a bearing on the purchasing power of ultimate consumers. Brazil.5 million tons. around 1. peaking during the subsequent two-three months. Brazil and Argentina with 5. the quantity of soy oil imports mainly depends on the price competitiveness of soy oil vis-a-vis its sole competitor. in and around which the crushing and solvent extraction units are mostly located. The production growth rate has been the highest for Argentina at 10. 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. Indian edible oil market is highly price sensitive in nature. spot markets of Indore and Mumbai serve as the reference market for soy oil prices.9 million tons during the last five years. Egypt. growing at the rate of 11.8%.92%). Andhra Pradesh and Gujarat also produce in small quantities. It has been growing at the rate of 5.
Price trends and factors the influence prices
Global and domestic demand-supply dynamics
Global consumption of soy oil during 2001-02 shot up to 29.8% compounded annually during the last decade. Imports constitute to the extent of over 65-68% of its annual soy oil requirement and 48% of its annual vegetable oil imports. Madhya Pradesh is considered as the soybean bowl of India. Soy oil is among the most vibrant commodities in terms of price volatility. Indore.36% compounded annually during the past decade. Of the total world exports.2-2. palm oil apart from prices of domestically produced oils. Central Europe. The refining units are located at the importing ports of Mumbai and Gujarat. Hence. with a market value of over Rs.1 and 4. contributing 80% of the country's soybean production. China and India. Production of soy oil in India has been fluctuating in the range of 0. In addition to domestic production. Uttar Pradesh. contribute to 17% and 14% of world production. It accounts to approximately 29% of world soy oil production with an annual production of 8. Crushing for oil and meal starts from October. Morocco. Mumbai price indicates the imported soy oil price. The consumption of soy oil in USA is to the extent of 90% of its production. etc.mainly me export-import policy.63%. US. Argentina contributes to an extent of 40. The current world production of soy oil stands at 29-30 million tons.6% and 2. followed by Maharashtra and Rajasthan. while that of Brazil and USA has been at 5. Karnataka.4%.
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. rapeseed is sown in the Rabi season (November-December sowing). As a result. Refining of rapeseed oil was almost absent in the country till the end of the last century. Crushing for oil begins from October onwards. The average oil recovery from the seed is about 33%. and the rest exported. The cake obtained from the seed crush contains some amount of oil.4. Mustard/ Rapeseed is traditionally the most important oil for the northern. which made refining and packing of all oils sold in the retail sector mandatory. traditional millers producing unrefined oil are more favoured by the consumers.
Cropping and growth patterns
Rapeseed is a 90-110 day crop. Now.
4. growing at a rate of 4. refining is present in rapeseed oil too. the sector was more unorganised when compared to the other edible oil sectors in the country.3%. This resulted in rampant adulteration of the oil. central and eastern parts of the country. It is largely consumed in the crude form in the local crushing regions. which is rich in proteins and is used as an ingredient in animal feed. part of which is consumed by the domestic animal feed industry. 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. Australia and China.5 Rapeseed oil
Rapeseed (also called mustard or canola) oil is the third largest edible oil produced in the world. concentration of production base in limited countries as against its widespread consumption base. The left over meal at the solvent extraction units forms a major portion of our oil meal basket. oil and meal are obtained. USA has been the fastest growing market for rapeseed oil. its close link with several of its substitutes and its base raw material soybean in addition to its co-derivative (soy meal). Mustard oil. Government of India issued the edible oil packaging order in 1998. In India.1 Agricultural commodities
exposure in the international edible trade scene (9-10 million tons). throw tremendous opportunity for trade in this commodity. the rapeseed is sown during the months of June-July and harvested by August-September. with the occurrence of dropsy in the country. Consumption in India and Canada has posted a negative growth
. The pungency of the oil is considered as the major quality determining factor. followed by China and European Union at 8% each. after soy and palm oils. In addition is the stiffening competition among substitutable oils under the WTO regime. which is extracted by the solvent extractors.1. Therefore. the nature of the existing supply and value chain. etc. In the countries of Canada. gets crushed for oil and cake in the ghanis or the expeller mills. which is known for its pungency. Rapeseed from the producers moves into the hands of crushers via the regulated markets (mandies). China also grows partly during this season. On crushing rapeseed. However. The remaining is obtained as oil cake/ meal. growing at the rate of 10.68% compounded annually during the period. is traditionally the most favoured oils in the major production tracts world over.
as lubricant. which is substantial. subjecting it to frequent fluctuations. Globally. Together. Rajasthan and Uttar Pradesh are the major rapeseed producing states in the country.8% and 4. soybean constitutes nearly 25% of the country's total oilseed production.46
Commodities traded on the NCDEX platform
rate of 6% and 1. Assam. susceptibility to the sentiments in the overall edible oil and meal industry in India and abroad.6% respectively.7% respectively. China contributes more than one thirds of world rapeseed oil production while that of India has gone down from 18. its erucic acid derivatives are used in plastic industry. and general sentiments in the overall edible oil industry within and outside the country. Rapeseed oil has several industrial applications too viz. Punjab and Jammu and Kashmir. Prices are largely dependent on the domestic production of rapeseed during the year.8% respectively during the past decade. There have been no imports of refined rapeseed oil for the last few years due to the differential duty structure. the nature of the existing supply and value chain. With an annual production of 5. it is undoubtedly the focus of Indian edible oil industry. The production from Rajasthan is highly monsoon dependent.
Price trends and factors the influence prices
Various production and trade related factors influence rapeseed oil trade. 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. north-eastern and western part of the country. Haryana. consumption of rapeseed oil is concentrated in northern. rapeseed oil accounts for about 12% of the total world's edible oil production.65%.2% and 7. It forms over one-third of the country's annual edible oil production.0-5. Bihar. owing to stiff price competition from palm and soy oils. whose share has been declining over the years. rapeseed oil production has witnessed a moderate compounded annual growth rate (over the last decade) of 4.2% in 1997 to 11. USA imports 50% of rapeseed oil traded at the international market.3% in 2001. influences the prices of the oil. While the production growth rates in major producing countries viz. wide consumption spread all through the year. Hong Kong and Russia are the major importers. The seasonal nature of the production of rapeseed and its vulnerability to natural fallacies.1. At an annual production level of 13-14 million tons. West Bengal. China. availability of others edible oils. Since the oil is known and consumed preferably for its unique pungency. Being an important source of edible oil.6 Soybean
The market size of the popularly known miracle bean in India is over Rs. The average monthly fluctuation in prices of soybean traded at one of the
4. Gujarat. and it could also be transformed into a liquid biofuel. France and Germany's rapeseed oil production during the period has been growing at 10%. Domestic rapeseed/ mustard is one of the major sources of edible oil and meal to India.5000 crore. Unlike other oils. they produce about 50% of the produce. The other significant producers are Madhya Pradesh. 6. 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 2001-02.4 million tons.
The market size of the popularly known miracle bean in India is over Rs. The planting date of vegetable soybean is dependent upon temperature and day length. vegetative growth and pod setting stages. During the past five years period. soybean prices in the major spot markets across the country have been fluctuating in the range of 5-9%. However.
Global and domestic demand-supply dynamics
About 82-85% of the global soybean production is crushed for oil and meal. the maximum monthly fluctuation being as high as 24-30% during the period. It supplies over 1. the production of the commodity grew at the rate of 5.4 million tons. provided a good amount of soil moisture is ensured at the germination. India and Taiwan are among the other major consumers. The commodity has been commercially exploited for its utility as edible oil and animal feed. it is a leading exporter of meal in the Asian region. The optimum temperature range of soybean cultivation is 20 . 6-7 lakh tons goes for direct consumption in the form of bean itself (sowing.
4.5000 crore.25%. Madhya Pradesh is the soybean bowl of India. China and European Union countries constitute for the bulk of world's annual soybean consumption. but the field should be well drained.2 million tons of
.19%. Karnataka.0-6. Uttar Pradesh.1.
Cropping and growth patterns
Soybean could be grown under rain fed conditions. around 18% oil could be obtained. Historically. On crushing mature beans. Soybean is the single largest oilseed produced in the world. Mexico.07% during the past two years. soybean production alone stands at 170-190 million tons.5 is suitable for its cultivation. followed by Brazil and Argentina are the major producing countries. Japan. Andhra Pradesh and Gujarat also produce in small quantities. human consumption as bean itself). Brazil. planting should be avoided at cooler temperatures during winter.5 million tons of oil (15-18% of India's annual edible oil requirement) and 3-3. With an annual production of 5. while the rest is consumed either in the form of bean itself or for value-added soybean snack foods. leaving the rest of the quantity for crushing for meal and oil. Of the total bean produced. USA. Argentina. which forms the prime source of protein in animal feeds. During the last decade. global consumption of soybean has grown at the rate of 5. soybean constitutes nearly 25% of the country's total oilseed production.4. Of the total 310-320 million tons of oilseeds produced annually.35% at the global level. higher than the production growth rate of 5.30°C with short day length (14 hours or less). India and China are among the other producers.0-5. USA. While the country imports soy oil. contributing to over 55% of the global oilseeds production. Loamy soil with pH of 6. followed by Maharashtra and Rajasthan.7 Rapeseed
Rapeseed/ Mustard is one of the major sources of oil and meal to India.1 Agricultural commodities
active soybean spot market at Indore (Madhya Pradesh) has been at 10. contributing 65-70% of the country's soybean production. the rest being the oil cake/ meal.
India. The commodity has been commercially exploited in the form of seeds.6%. The hybrid form of rapeseed. growing at the rate of 10. The average monthly fluctuation in prices of rapeseed traded at one of the active rapeseed spot market at Jaipur (Rajasthan) has been at 9. and declined from there on to the current (2002) level of 32.4% during the period. Australian rapeseed production grew at the fastest rate of 21%. India and Canada have shown a decline
.6% respectively. Sarson is suited to light-loam soils and Taramira is mostly grown on very light soils.
Cropping and growth patterns
Under the names rapeseed and mustard. It has been growing at the rate of 2.48
Commodities traded on the NCDEX platform
oil meal. known as canola. followed by China and European Union at 8% each. The major contributors to global rapeseed production are China. Among the major contributors to world production. The other major producers are Germany. France. Consumption in India and Canada has posted a negative growth rate of 6% and 1. whose share has been declining over the years.8% during the past two years (July 2001 to July 2003).68% compounded annually during the period. Rapeseed/ Mustard/ Canola is a traditionally important oilseed.1%. France and Germany are growing at a moderate rate of 2-4%.5 million tons. Germany. Rapeseed and mustard thrive best in light to heavy loams.8% and 3% respectively. the maximum monthly fluctuation being as high as 23. whereas Rai and Toria are grown in medium and high rainfall areas respectively. Canada and India are the major producers of this commodity. In India. Rai may be grown on all types of soils. Brown mustard.3%. several oilseeds belonging to the cuciferae are grown in India. 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.4 million tons in 1999. 12. Sarson is preferred in low-rainfall areas.2% during the last 12 years period. oil (seed to oil recovery is 39-40%) and meal. Sarson: (i) Yellow sarson (ii) Brown sarson
3. the major protein source in animal feeds. Rapeseed and mustard crops grow well in areas having 25 to 40 cm of rainfall. growing at a rate of 4. commonly called rai (raya or laha) 2. 12. but Toria does best in loam to heavy loams. Pakistan and Poland. USA imports 50% of rapeseed oil traded at the international market. While China. Australia. Canada and Australia with a share of 32%. 9. They are generally divided into three groups:
1. is more popular internationally. France. Hong Kong and Russia are the major importers. USA has been the fastest growing market for rapeseed oil. China. they are grown during the Rabi season from September-October to February-March. 10%. Global production of rapeseed increased from 25 million tons in 1990 to 42.
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.
4.2 Precious metals
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.
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
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
Share, 1999 17 12 6 13 6 6 2 18 100
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.
Regarding pattern of demand. If gold is held primarily as an investment asset. a preferred form of wealth for women. 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. The yellow metal used to
. Middle East and China. More than 80% of the gold consumed is in the form of jewellery. There is reason to believe that a part of investment demand for gold assets is out of black money. The Indian demand to the tune of 800 tonnes per year is making it the largest market for gold followed by USA. Barely 5% is for industrial uses. it does not need to be held in physical form. the available evidence shows that about 80% is for jewellery fabrication for domestic demand. ritualistic. inaccessible or insecure banks. 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
The Consumer demand for gold is more than 3400 tonnes per year making it whopping $40 billion worth.). 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. and as a hedge against inflation.religious. These two countries together account for over 50% of total world demand of gold for retail investment. financial markets. Investment demand can be split broadly into two. There are several ways in which investors can invest in gold either directly or through a variety of investment products. It would not be realistic to assume that it is only the affluent that creates demand for gold. If we include jewellery ownership. which is generally predominated by women. or where trust in the government is low. gold is attractive as a store of value. Japan has the highest investment demand for gold followed closely by India. and 15% is for investor-demand (which is relatively elastic to gold-prices. then India is the largest repository of gold in terms of total gold within the national boundaries. The demand for gold jewellery is rooted in societal preference for a variety of reasons . and to treat any major part as exclusively a store of value or hedging instrument would be unrealistic. tax-policies. there are no authentic estimates. real estate prices.52
Commodities traded on the NCDEX platform
In markets with poorly developed financial systems. It will be difficult to prioritise them but it may be reasonable to conclude that it is a combined effect. etc. 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. private and public sector holdings.
In the near future. The changeover hands of gold at the time of marriage are from few grams to kgs. and still is. The demand-supply for gold in India can be summed up thus:
• Demand for gold has an autonomous character. where women did not inherit landed property whereas gold and silver jewellery was. so price strength in March and April is not uncommon.
Price trends and factors that influence prices
Indian gold prices follow more or less the international price trends. Although it is likely that. particularly in urban areas. Supply follows demand. a major component of the gifts given to a woman at the time of marriage. gold prices tend to increase during the time of year when demand for jewellery is greatest. It rose almost more than 40% compared to the previous year because of rise in gold price by more than 15%. Christmas. The availability of recycled gold is price sensitive and as such the dominance of the gold supply through import is in existence. Since the demand for gold is closely tied to the production of jewelry. particularly illegal import prior to the commencement of
liberalisation in 1990. 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. The annual consumption of gold. On the
. However. the annual demand will continue to be over 600 tonnes per year. particularly in the rural and semi-urban areas. One fourth of world gold production is consumed in India and more than 60% of Indian consumption is met through imports. 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. therefore. Also. which are predominantly private. The domestic production of the gold is very limited which is around 9 tonnes in 2002 resulting more dependence on imported gold. with prosperity and enlightenment. there may be deceleration in demand.
Indian gold holding.2 Precious metals
play an important role in marriage and religious festivals in India. has increased to more than 700 tonnes in late 90s. which lies in the social and cultural system of India. The fabricated old gold scraps is price elastic and was estimated to be near 450 tonnes in 2002.
• Price differential creates import demand. the summer wedding season sees a large increase in the demand for metals. it would be made good by growing demand on account of prosperity in rural areas. which was estimated at 65 tonnes in 1982. These temples are run in trust and gold with the trust rarely comes into re-circulation. • Demand exhibits income elasticity. is estimated to be in the range of 1000013000 tonnes. Jain and Sikh community. 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. In the Hindu.4. 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.
Though futures trading was banned in India since late sixties. photography and jewelry & silverware. In recent years.54
Commodities traded on the NCDEX platform
other hand in November. Most of the world's silver is mined in the US. followed by Canada. and Canada. India annually consumes around 4. Australia.2 Silver
The dictionary describes it as a white metallic element. Cash markets remain highly unorganised in the silver and impurity and excessive speculation remain key issue for the trade. Peru. 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.
. which is the worlds largest consumer of silver. Japan and India. With the growing use of silver in photography and electronics. and Australia. Taking cue from gold.000 tonnes of silver. government of India is planning to introduce hallmarking in silver which is likely to address quality and credibility of Indian silverware and jeweller industry. silver has remained a hot favourite speculative vehicle for the small time traders. MP and UP are the active pockets for the silver futures.
4. Thanks to its unique volatility. industrial and decorative uses. Delhi. Silver is somewhat harder than gold and is second only to gold in malleability and ductility. parallel futures markets are still very active in Delhi and Indore. industrial production. these three categories represent more than 95 percent of annual silver consumption. income levels. industrial demand for silver accounts for roughly 85% of the total demand for silver. Jewelry and silverware is the second largest component. very malleable and capable of high degree of polish. the United States. Germany. Mexico is the worlds leading producer of silver. Rajkot and Mathura were conducting futures but now players have diverted toward comex trade. France. Canada. and silver has been mined and treasured longer than any of the other precious metals. Until recently. and a whole host of other financial macro economic indicators. Mexico. The unique properties of silver restrict its substitution in most applications. followed by Peru. December.
Demand for silver is built on three main pillars. the United Kingdom. Rajasthan. Mexico. with more demand from the flatware industry than from the jewelry industry in recent years. sonorous. January and February prices tend to decline and jewellers tend to have holiday inventory to unwind. The main consumer countries for silver are the United States. is gearing up to start hallmarking of the white precious metal by April. Italy. the largest consumer of silver. Together.
Silver ore is most often found in combination with other elements. The main factors affecting these countries demand for silver are macro economic factors such as GDP growth. Silver remains one of the most prominent candidates in the metals complex as far as futures' trading is concerned. India. but industrial. It also has the highest thermal and electrical conductivity of any substance. the main world demand for silver is no longer monetary. ductile.2.
a precious metals company. The most notable producers are Mexico. Scrap supply increased marginally last year up by 1. the largest producer of silver from mines.2 Precious metals
Major markets like the London market (London Bullion Market Association). after a gap of 30 years. disinvestments. Scrap is the silver that returns to the market when recovered from existing manufactured goods or waste. or actual mine capacity. buying and selling orders. In the United States. publishes a price for 99. the price is fixed at the point at which all the members of the fixing can balance their own. Known reserves.
The supply of silver is based on two facts. the silver used in solvents and the like can be removed from the waste and recycled. In the United States and Japan. India's demand for silver increased by 177 per cent over the past 10 years as compared to 517 tonnes in 1991. The London market has a fix which offers the chance to buy or sell silver at a single price. and is a balancing exercise.4. Trading in silver futures resumed at the Comex in New York in 1963. the most significant paper contracts trading market for silver in the United States is the COMEX division of the New York Mercantile Exchange. Although there is no American equivalent to the London fix.6 million ounces. accounting for roughly 27. mainly in the form of spent fixer solutions and old X-ray films. It normally accounts for a little less than 2/3 rd of the total (last year was slightly higher at 68%). respectively. Silver is often mined as a byproduct of other base metal operations. accounting for roughly 43. The London Metal Exchange and the Chicago Board of Trade introduced futures trading in silver in 1968 and 1969. According to GFMS. is evenly split along the lines of production. Canada and Australia. Old scrap normally makes up around a fifth of supply.2%. Handy & Harman. Box 4.8 million troy ounces in 1997. or on a forward basis. the United States. as well as by the chemical industry. Although London remains the true center of the physical silver trade for most of the world. Mexico.
. The mine production is not the sole source . plus clients. Peru. The other major source of silver is from refining. which started trading in the 17th century provide a vehicle for trade in silver on a spot basis. three-quarters of all the recycled silver comes from the photographic scrap. Because silver is used in the photography industry. or scrap recycling. The fix begins at 12:15 p.5: Historical background of silver markets
with the rural areas accounting for the bulk of the sales.9% pure silver at noon each working day.others being scrap. government sales and producers hedging. mine production and recycled silver scraps. The United States recycles the most silver in the world. Japan is the second largest producer of silver from scrap and recycling. which accounts for roughly four-fifths of the mined silver supply produced annually. the Commodity Futures Trading Commission (CFTC). Spot prices for silver are determined by levels prevailing at the COMEX. the silver futures market functions under the surveillance of an official body. Peru is the worlds second largest producer of silver. India has emerged as the third largest industrial user of silver in the world after the US and Japan. Mine production is surprisingly the largest component of silver supply. Fifteen countries produce roughly 94 percent of the worlds silver from mines.m.
die production of silver increases in tandem. are dictated by forces of demand and supply and consumption. •• 3. a host of social. It is not a product mat can be manufactured en masse. Silk 4. the threat affects the price of silver too. ___ is the most important non-food crop. Q: In India. technological change and market liberalisation. When trading and movement of silver is restricted. and. Besides. Because silver is a precious metal. within or outside national boundaries. political tensions. Silver 4. 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). and fluctuations in deficits and interest rates. Wheat 2. and zinc. Although prices and incomes are important factors. 1. 3. lead. is subject to issues such as weamer and politics mat may affect silver mining operations. etc.56
Commodities traded on the NCDEX platform
Factors influencing prices of the silver
The prices of silver. Soy oil ••
. economic and political factors have powerful bearing on silver prices. die increased profit margin to mine operations stimulates greater production of die omer metals. changing values of paper currencies. None of the above. and as a result. the price of these metals greatly affects the supply of silver mined in any year. As die price of die omer metal products increases. Soybean 4. there is a limited amount of silver in the world. its price is determined by die supply and demand ratio at any given moment. As is the case with other precious metals. like that of other commodities. Gold 2. Jute 2. nickel. As in the case of gold prices. Approximately 70 percent of the silver mined in the western hemisphere is mined as a byproduct of other metal products. they are also influenced by factors such as tastes. Rapeseed A: The correct answer is number 1. As such.
Q: Which of the following commodities do not trade on the NCDEX? 1. Cotton A: The correct answer is number 2. Rapeseed A: The correct answer is number 4. copper. merefore. Energy ••
Q: Which of the following agricultural commodities do not trade on the NCDEX at the moment? 1. such as gold. 3.
CPO 4. Q: Soy oil is the derivative of 1. Q: Palm oil is extracted from the __ of oil palm plantations. Stem 4. Prices sunflower oil 3. SGX 3. Previous prices of cotton 4.
. Sunflower seeds 3. 1. 3. Soybean A: The correct answer is number 2. Soy 2. Production and prices of synthetic fibre A: The correct answer is number 4. Prices of CPO 4. Rapeseed A: The correct answer is number 3. Leaves 3. Dry fruit bunches A: The correct answer is number 1. Demand-supply scenario 2. CPO 4. Prices of Rapeseed oil 2.2 Precious metals Q: Which of the following factors do not influence the price of cotton? 1. Q: Futures prices of cotton at the __ serve as the reference price for cotton traded in the international market. NYBOT 4. Prices of cotton products. CME 2. Q: RBD Palmolein is the derivative of 1. 1. Mature fresh fruit bunches 2. Soy 2.4. Prices of coconut oil A: The correct answer is number 3. Q: Which of the following factor directly influences the price of RBD palmolein? 1. CBOT A: The correct answer is number 3. Coconut kernel 3.
Indore 4. Q: The ____ market reflects the price of imported soybean 1. Mumbai 2. Ahmedabad A: The correct answer is number 1. 3. Ahmedabad A: The correct answer is number 3.58
Commodities traded on the NCDEX platform
Q: The ____ market reflects the price of domestically crushed soybean 1. Mumbai 2. Delhi ••
. Delhi •• 3. Indore 4.
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. forward contracts are popular on the OTC market. price and quantity are negotiated bilaterally by the parties to the contract. While at the moment only commodity futures trade on the NCDEX.
5. Other contract details like delivery date. derivatives have become increasingly popular due to their applications for hedging. it has to compulsorily go to the same counterparty. thereby reducing transaction costs and increasing transactions volume.
However forward contracts in certain markets have become very standardised. The other party assumes a short position and agrees to sell the asset on the same date for the same price. While futures and options are now actively traded on many exchanges. The salient features of forward contracts are:
• They are bilateral contracts and hence exposed to counter-party risk.
. In this chapter we shall study in detail these three derivative contracts. which
often results in high prices being charged. • The contract price is generally not available in public domain. speculation and arbitrage. we will have a look at some basic derivative products. Before we study about the applications of commodity derivatives. as in the case of foreign exchange. eventually.
• If the party wishes to reverse the contract. we also have commodity options being traded. and hence is unique in terms of contract size. expiration date and the asset type and quality. the contract has to be settled by delivery of the asset.1
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. as the market grows. The forward contracts are normally traded outside the exchanges. • On the expiration date. This process of standardisation reaches its limit in the organised futures market. • Each contract is custom designed.Chapter 5 Instruments available for trading
In recent years.
wait for the price to rise. Counterparty risk arises from the possibility of default by any one party to the transaction. and hence avoid the problem of illiquidity. • Illiquidity. the other suffers. By using the currency forward market to sell dollars forward. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. and then take a reversing transaction to book profits. He is exposed to the risk of exchange rate fluctuations. More than 99% of futures transactions are offset this way. the exchange specifies certain standard features of the contract. Speculators may well be required to deposit a margin upfront.1. (or which can be used for reference purposes in settlement) and a standard timing of such settlement. but makes the contracts non-tradeable. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. It is a standardized contract with standard underlying instrument. However. and • Counterparty risk
In the first two of these. which forecasts an upturn in a price. 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. Even when forward markets trade standardized contracts. then he can go long on the forward market instead of the cash market. a standard quantity and quality of the underlying instrument that can be delivered. But unlike forward contracts.2 Introduction to futures
Futures markets were designed to solve the problems that exist in forward markets. still the counterparty risk remains a very serious issue. The standardized items in a futures contract are:
. To facilitate liquidity in the futures contracts.1
Limitations of forward markets
Forward markets world-wide are afflicted by several problems:
• Lack of centralisation of trading.
5. The use of forward markets here supplies leverage to the speculator. the basic problem is that of too much flexibility and generality. When one of the two sides to the transaction declares bankruptcy. 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.
5. The speculator would go long on the forward.60
Instruments available for trading
Forward contracts are very useful in hedging and speculation. If a speculator has information or analysis. the futures contracts are standardized and exchange traded. This often makes them design terms of the deal which are very convenient in that specific situation. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. he can lock on to a rate today and reduce his uncertainty. this is generally a relatively small proportion of the value of the assets underlying the forward contract.
1 lists the distinction between the two. and the Chicago Board Options Exchange. the underlying value of all contracts traded at the Chicago Mercantile Exchange totalled 50 trillion dollars. Before IMM opened in 1972. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. A division of the Chicago Mercantile Exchange. By 1990. The brain behind this was a man called Leo Melamed. it was called the International Monetary Market (EMM) and traded currency futures." The first exchange that traded financial derivatives was launched in Chicago in the year 1972. the Chicago Board of Trade. these exchanges were trading futures and options on everything from Asian and American stock indexes to interest-rate swaps. the 1990 Nobel laureate had said that "financial futures represent the most significant financial innovation of the last twenty years.5.2 Introduction to futures
Merton Miller.6: The first financial futures market
Table 5. acknowledged as the "father of financial futures" who was then the Chairman of the Chicago Mercantile Exchange.
Distinction between futures and forwards contracts
Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. and their success transformed Chicago almost overnight into the risk-transfer capital of the world.2. the Chicago Mercantile Exchange sold contracts whose value was counted in millions.
. Table 5.1 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. These currency futures paved the way for the successful marketing of a dizzying array of similar products at the Chicago Mercantile Exchange. By the 1990s.
Instruments available for trading
5.2. Thus a January expiration contract expires on the 20th of January and a February expiration contract ceases trading on the 20th of February.2 Futures terminology
• Spot price: The price at which an asset trades in the spot market. This is the last day on which the contract will be traded. the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. An option gives the holder of the option the right to do something. This is called marking-to-market. we look at another interesting derivative contract.
• Maintenance margin: This is somewhat lower than the initial margin. The commodity futures contracts on the NCDEX have one-month. The delivery unit for the Gold futures contract is 1 kg. at the end of which it will cease to exist. Options are fundamentally different from forward and futures contracts. This is set to ensure that the
balance in the margin account never becomes negative. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. On the next trading day following the 20th. the purchase of an option requires an up-front payment. ■ 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. 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. • 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. in a forward or futures contract. • Delivery unit: The amount of asset that has to be delivered under one contract. • Marking-to-market(MTM): In the futures market. • Contract cycle: The period over which a contract trades. two-months and three-months expiry cycles which expire on the 20th day of the delivery month. basis will be positive. Whereas it costs nothing (except margin requirements) to enter into a futures contract. a new contract having a three-month expiry is introduced for trading. This reflects that futures prices normally exceed spot prices.
5. In a normal market. For instance. namely options. • Basis: Basis can be defined as the futures price minus the spot price. • Expiry date: It is the date specified in the futures contract. There will be a different basis for each delivery month for each contract. at the end of each trading day. the delivery unit for futures on Long Staple Cotton on the NCDEX is 55 bales. The holder does not have to exercise this right. the two parties have committed themselves to doing something. If the balance in the margin account falls below the maintenance margin. • Futures price: The price at which the futures contract trades in the futures market. In contrast.
.3 Introduction to options
In this section.
In 1973. there was no mechanism to guarantee that the writer of the option would honour the contract. • 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. they were traded OTC. there was no secondary market and second. The first trading in options began in Europe and the US as early as the seventeenth century.3. ■ Stock options: Stock options are options on individual stocks. there has been no looking back. the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE.5. If no seller could be found. Merton and Scholes invented the famed Black-Scholes formula. 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. Options currently trade on over 500 stocks in the United States. the exercise date.
. • Strike price: The price specified in the options contract is known as the strike price or the exercise price. Since then. The market for options developed so rapidly that by early '80s. Black. In April 1973. without much knowledge of valuation. he or she would contact one of the member firms.3 Introduction to options
Although options have existed for a long time. First. • 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. A contract gives the holder the right to buy or sell shares at the specified price. • 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.7: History of options
5. • Option price: Option price is the price which the option buyer pays to the option seller. the strike date or the maturity. 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. This market however suffered from two deficiencies. If someone wanted to buy an option. 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.1
■ Commodity options: Commodity options are options with a commodity as the underlying. CBOE was set up specifically for the purpose of trading options. Box 5. • 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. There are two basic types of options. the firm would undertake to write the option itself in return for a price. ■ Expiration date: The date specified in the options contract is known as the expiration date. call options and put options. It is also referred to as the option premium.
the intrinsic value of a put is Max [0. If the index is much higher than the strike price.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. • At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately.
. spot price < strike price).i. In the case of a put. At expiration. the call is said to be deep OTM.64
Instruments available for trading
• American options: American options are options that can be exercised at any time upto the expiration date. In this section we shall take a look at the payoffs for buyers and sellers of futures and options.
5. An option on the index is at-the-money when the current index equals the strike price (i. (K . spot price = strike price). the greater is an option's time value.
• Time value of an option: The time value of an option is the difference between its premium and its
intrinsic value. • 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. (St .e. the put is OTM if the index is above the strike price. K is the strike price and St is the spot price. the greater of 0 or (K . Both calls and puts have time value. 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. an option should have no time value. European options are easier to analyse than American options.intrinsic value and time value. Putting it another way. and properties of an American option are frequently deduced from those of its European counterpart. The longer the time to expiration. Similarly. If the call is OTM. the intrinsic value of a call is Max [0. if it is ITM. Most exchange-traded options are American.St). The asset could be a commodity like gold or cotton. An option that is OTM or ATM has only time value.St )]. The intrinsic value of a call is the amount the option is ITM.e. • European options: European options are options that can be exercised only on the expiration date itself. In the case of a put. • 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 maximum time value exists when the option is ATM. 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. If the index is much lower than the strike price.K). all else equal.K)] which means the intrinsic value of a call is the greater of 0 or (St .e. its intrinsic value is zero. the call is said to be deep ITM. the put is ITM if the index is below the strike price. But first we look at the basic payoff for the buyer or seller of an asset. or it could be a financial asset like like a stock or an index. spot price > strike price). • Intrinsic value of an option: The option premium can be broken down into two components .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. Usually.
1 Payoff for buyer of asset: Long asset
In this basic position. tulip-bulb growers could assure themselves of selling their bulbs at a set price by purchasing put options. He has a potentially unlimited upside as well as a potentially unlimited downside. Figure 5. The first tulip was brought into Holland by a botany professor from Vienna. Hardest hit were put writers who were unable to meet their commitments to purchase Tulip bulbs.5 Payoff for futures
Options made their first major mark in financial history during the tulip-bulb mania in seventeenth-century Holland. St. That was when options came into the picture. an investor shorts the underlying asset.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. gold for instance. the buyer makes profits.5. The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money. the buyer makes losses. Box 5. and sells it at a future date at an unknown price. the tulip became the most popular and expensive item in Dutch gardens. The magnitude of profits or losses for a given upward or downward movement is the same. Similarly. the more Tulip bulb prices began rising.
5. the investor is said to be "short" the asset.4. cotton for instance. a dealer who was committed to a sales contract could be assured of obtaining a fixed number of bulbs for a set price. The more popular they became.2 Payoff for seller of asset: Short asset
In this basic position.
5. Later. a call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs themselves.8: Use of options in the seventeenth-century
5. for Rs. The profits as well as losses for the buyer and the seller of a futures contract are unlimited. If the price of the underlying rises. for Rs. just like the payoff of the underlying asset that we looked at earlier.6500 per Quintal. an investor buys the underlying asset. however. and buys it back at a future date at an unknown price.
. By purchasing a call option on tulip bulbs.1 shows the payoff for a long position on gold.4. options were increasingly used by speculators who found that call options were an effective vehicle for obtaining maximum possible gains on investment.5 Payoff for futures
Futures contracts have linear payoff. As long as tulip prices continued to skyrocket. 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. If the price of the underlying falls.2 shows the payoff for a short position on cotton. It was one of the most spectacular get rich quick binges in history. Once it is sold. Over a decade. They were initially used for hedging. St.5.
5. Once it is purchased. Figure 5. the investor is said to be "long" the asset.6000 per 10 gms. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs.
he profits. 65000 per Quintal.1 Payoff for a buyer of gold
Instruments available for trading
The figure shows the profits/losses from a long position on gold.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. If price of gold falls he looses. he profits. 6000 per 10 gms. If the price of cotton falls. The investor brought gold at Rs. he looses. The investor sold long staple cotton at Rs. Figure 5.66.
If the price of gold falls. The underlying asset in this case is gold. When the prices of long staple cotton move up. When the prices of long staple cotton move down.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.
.5.5.6000 per 10 gms. He has a potentially unlimited upside as well as a potentially unlimited downside. If the price of the underlying gold goes up. When the prices of gold in the spot market goes up.
5. the futures prices too move down and the long futures position starts making losses. the gold futures price too would go up and his futures position starts making profit. The underlying asset in this case is long staple cotton.6500 per Quintal. the futures price too moves up and the long futures position starts making profits. the cotton futures price also moves up and the short futures position starts making losses. the cotton futures prices also move down and the short futures position starts making profits.5 Payoff for futures Figure 5.6000 per 10 gms.
Take the case of a speculator who buys a two-month gold futures contract on the NCDEX when it sells for Rs. Figure 5. Take the case of a speculator who sells a two-month cotton futures contract when the contract sells Rs. Similarly when the prices of gold in the spot market goes down.3 Payoff for a buyer of gold futures
The figure shows the profits/ losses for a long futures position. Figure 5.4 shows the payoff diagram for the seller of a futures contract.The investor bought futures when gold futures were trading at Rs.3 shows the payoff diagram for the buyer of a gold futures contract. the futures price falls too and his futures position starts showing losses.
Higher the spot price.6.
5.6500 per Quintal. If the price of the underlying long staple cotton rises.6 Payoff for options
The optionality characteristic of options results in a non-linear payoff for options.68 Figure 5. however the profits are potentially unlimited. His profits are limited to the option premium. and the short futures position starts showing losses. If the price of the underlying long staple cotton goes down. We look here at the four basic payoffs. he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. In simple words.4 Payoff for a seller of cotton futures
Instruments available for trading
The figure shows the profits/ losses for a short futures position. the futures price also falls. the spot price exceeds the strike price. it means that the losses for the buyer of an option are limited.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. bought at a premium of Rs. the futures too rise. 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. The writer of an option gets paid the premium. The investor sold cotton futures at Rs. If upon expiration. more is the profit he makes. The payoff from the option written is exactly the opposite to that of the option buyer. however his losses are potentially unlimited.7000 per 10 gms. If the spot price of the underlying is less than the strike price.
5. Figure 5. The profit/ loss that the buyer makes on the option depends on the spot price of the underlying.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.500. and the short futures position starts making profit. he makes a profit.
The profits possible on this option are potentially unlimited.6.7000 per 10 gms. Figure 5. sold at a premium of Rs. the writer of the option charges a premium. As can be seen.5. Hence as the spot price increases the writer of the option starts making losses.6. the call option becomes in-themoney. he lets the option expire. If upon expiration.7000 per 10 gms. the buyer would exercise his option and profit to the extent of the difference between the spot gold-close and the strike price. the spot price exceeds the strike price.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. gold trades above the strike of Rs. If upon expiration the spot price of the underlying is less than the strike price. Higher the spot price. as the prices of gold rise in the spot market. the buyer will exercise the option on the writer. The profit/ loss that the buyer makes on the option depends on the spot price of the
. The profit/ loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration. 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.6 Payoff for options Figure 5.5 Payoff for buyer of call option on gold
The figure shows the profits/ losses for the buyer of a three-month call option on gold at a strike of Rs.500.6 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. For selling the option. Whatever is the buyer's profit is the seller's loss. the buyer lets his option expire un-exercised and the writer gets to keep the premium.
5.2 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.7000.
5. more is the loss he makes.7000.
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. Figure 5. 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. more is the profit he makes. the buyer lets his option expire un-exercised and the writer gets to keep the premium. For selling the option. the buyer will exercise the option on the writer. Whatever is the buyer's profit is the seller's loss. the spot price happens to be below the strike price.6000 per Quintal.70 Figure 5.
5. gold price is above the strike of Rs. the call option becomes in-the-money and the writer starts making losses.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 profit/ loss that the buyer makes on the option depends on the spot price of the underlying. Lower the spot price. His loss in this case is the premium he paid for buying the option.400.6. bought at a premium ofRs. As the price of gold in the spot market rises. Figure 5.7000.4 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. If upon expiration.500 charged by him. the spot price is below the strike price. The loss that can be incurred by the writer of the option is potentially unlimited. If upon expiration.6000 per Quintal. the writer of the option charges a premium.7000 per 10 gms. If upon expiration the spot price of the underlying is more than the strike price. he lets his option expire un-exercised.
. If upon expiration. whereas the maximum profit is limited to the extent of the up-front option premium of Rs. If the spot price of the underlying is higher than the strike price. he makes a profit.
His losses are limited to the extent of the premium he paid for buying the option. he lets the option expire. which is free to enter into. As can be seen. options offer "nonlinear payoffs" whereas futures only have "linear payoffs".5.when would one use options instead of futures? Options are different from futures in several interesting senses. he only has an upside. After this.7 Using futures versus using options
An interesting question to ask at this stage is .
5. However if spot price of cotton on the day of expiration of the contract is above the strike of Rs. but can generate very large losses.
sold at a premium of Rs. If at expiration. Rs. By combining futures and options.400.7 Using futures versus using options
Figure 5. More generally. as the price of cotton in the spot market falls. a wide variety of innovative and useful payoff structures can
. This characteristic makes options attractive to many occasional market participants.400 in this case. the buyer would exercise his option and profit to the extent of the difference between the strike price and spot cotton-close. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option).7 Payoff for buyer of put option on long staple cotton
The figure shows the profits/ losses for the buyer of a three-month put option on long staple cotton. At a practical level. This is different from futures. who cannot put in the time to closely monitor their futures positions.6000 per Quintal.6000. the option buyer faces an interesting situation. cotton prices fall below the strike of Rs. He pays for the option in full at the time it is purchased. The profits possible on this option can be as high as the strike price. the put option becomes in-the-money.
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. As the price of cotton in the spot market falls.
Table 5.400. the put option becomes in-the-money and the writer starts making losses. Price is always positive.72
Instruments available for trading
Figure 5.6000 per Quintal. i. 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.
. cotton prices fall below the strike of Rs.e. price moves.
be created. 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. Same as futures. If upon expiration. The profit that can be made by the writer of the option is limited to extent of the premium received by him. Strike price is fixed. Only short at risk. with novation Exchange defines the product Price is zero. Nonlinear payoff. strike price moves Price is zero Linear payoff Both long and short at risk Same as futures.2 Distinction between futures and options Futures Options Exchange traded. Rs.
Unlimited A: The correct answer is number 2. Cotton 4. Wheat 2.
Q: The potential returns on a futures position are: 1. Exchange ••
A: The option to exercise lies with the buyer.7 Using futures versus using options
Q: Which of the following cannot be an underlying asset for a financial derivative contract? 1. Chicago Board of Trade 2. Buyer 2. Seller 3. the option lies with the 1. Foreign exchange ••
Q: Which of the following cannot be an underlying asset for a commodity derivative contract? 1. Both 4. a function of the volatility of the index 4. Chicago Mercantile Exchange A: The correct answer is 3.5. 3. None of the above ••
. Equity index 2. Commodities A: The correct answer is 2 3. Interest rate 4. London International Financial Futures and Options Exchange ••
Q: In an options contract. Gold A: The correct answer is 4 3. Stocks ••
Q: Which of the following exchanges was the first to start trading commodity futures? 1. The correct answer is number 1. 3. Limited 2. Chicago Board Options Exchange 4.
The correct answer is number 1. None of the above ••
Q: An asset currently sells at 120.50/Quintal. Rs. A week later soy bean futures trade at Rs. (+)5000 2. and delivery unit is 100 Quintals. He buys 10 units which means a futures position 100 Quintals. 1500/Quintal. Futures contract 2. 3.400/ gm. This is an example of a 1. Forward contract A: The correct answer is number 2. The time value of the option is 1.14 4. OTC contract 2. Greater than the sum of intrinsic value and time value value A: The correct answer is number 3. Q: Typically option premium is 1. He makes a profit of Rs.18 2. Less than the sum of intrinsic value and time time value 2. 1550/Quintal. Spot contract 4.134 costs Rs.400/ gm.000
A: Each unit is for 10 Quintals.000 4.5000. Rs. i. (+)50. • •
. Exchange traded contract A: The correct answer is number 1. he makes a profit of Rs. Rs. None of the above ••
Q: Unit of trading for soy bean futures is 10 Quintals.18.74
Instruments available for trading
Q: Two persons agree to exchange 100 gms of gold three months later at Rs. A trader buys futures on 10 units of soy bean at Rs. 3. (-)5000 3. This is an example of a 1. Independent of intrinsic value and time 3. Rs.12 ••
Q: Two persons agree to exchange 100 gms of gold three months later at Rs. 3. (-)50. How much profit/loss has he made on his position? 1.e. Spot contract 4. The put option to sell the asset at Rs.4 A: The correct answer is number 2. Equal to the sum of intrinsic value and value 4.
(+) 10. i. How much profit/loss has he made on his position? 1.e. He makes a loss of Rs.5000.7000) .000 4.5000.000
A: Each unit is for 10 Quintals. A trader buys futures on 10 units of soy bean at Rs.e. (+) 1. He makes a profit of Rs. The correct answer is number 2.000
A: Each unit is for 10 Quintals.000 4. (+)50. (-)5000 3.000 4.70]. (+)50. A week later soy bean futures trade at Rs. he makes a loss of Rs. and delivery unit is 100 Quintals.50/Quintal.000 2. he makes a loss of Rs. How much profit/loss has he made on his position? 1.5000. A trader sells futures on 10 units of soy bean at Rs. 1500/Quintal. • • 10
. (+)50. A week later soy bean futures trade at Rs. 1450/Quintal. A week later soy bean futures trade at Rs. 1000 on his position
100 × 10 The correct answer is number 2. and delivery unit is 100 Quintals. (-) 1. • • Q: Unit of trading for soy bean futures is 10 Quintals. (-)5000 3.7080/10 gms. 1500/Quintal. 1550/Quintal.[(7080 .70. he makes a profit of Rs. (-) 10. The correct answer is number 1.000
A: Per 10 gms he makes a net profit of Rs. (-)50.e. He buys 10 units which means a futures position in 100 Quintals. the spot price of gold is Rs. 1500/Quintal. 1450/Quintal. He has a long position in 1000 gms. He makes a loss of Rs. i. • •
Q: Unit of trading for soy bean futures is 10 Quintals. i. (+)5000 2. (-)50. So he makes a net profit of Rs. A trader sells futures on 10 units of soy bean at Rs.000
A: Each unit is for 10 Quintals. (-)5000 3.50/Quintal.50/Quintal. and delivery unit is 100 Quintals. He sells 10 units which means a futures position in 100 Quintals.000 4. i.5.000 3. Unit of trading is 100 gms. How much profit/loss has he made on his position? 1. The correct answer is number 2. • • Q: A trader buys three-month call options on 10 units of gold with a strike of Rs. (-)50. What is his net payoff? 1. (+)5000 2.7000/10 gms at a premium of Rs.10. On the day of expiration.e. He buys 10 units which means a futures position in 100 Quintals.7 Using futures versus using options
Q: Unit of trading for soy bean futures is 10 Quintals. (+)5000 2.
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.
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
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
equation 6.2 is expressed as:
F . Then we introduce real world factors as they apply to investment commodities and later to consumption commodities. When we use continuous compounding. there would be opportunities for arbitrage. Suppose that the forward price is relatively high at Rs. We begin with a forward contract on an asset that provides the holder with no income and has no storage or other costs.05 × 0.50. and sell the stock in the forward market at Rs. buy one share in the spot market. Pricing of options and other complex derivative securities requires the use of continuously compounded interest rates.50 at the end of the three month period. To understand the pricing of commodity futures.40 and the three-month interest rate is 5% per annum.00 .SerT where: r Cost of financing (using continuously compounded interest rate) T Time till expiration e 2. In the case of equity futures. Consider a three-month forward contract on a stock that does not pay dividend.2. the holding cost is the cost of financing minus the dividends returns.a forward contract. the arbitrager delivers the share and receives Rs.43. Most books on derivatives use continuous compounding for pricing futures too. the arbitrager locks in a profit of Rs.3)
So far we were talking about pricing futures in general. In the case of commodity futures.2 uses the concept of discrete compounding.43.
. Assume that the price of the underlying stock is Rs.40. By following this strategy. where interest rates are compounded at discrete intervals. We use examples of forward contracts to explain pricing concepts because forward contracts are easier to understand. We know what are the spot and futures prices. let us start with the simplest derivative contract .50 = Rs.6. We consider the strategies open to an arbitrager in two extreme situations. Equation 6.25 − 40. for example. arbitrage would exist. However. but what are the components of holding costs? The components of holding cost vary with contracts on different assets. An arbitrager can borrow Rs. The sum of money required to pay off the loan is 40e 0.40 from the market at an interest rate of 5% per annum. At times the holding cost may even be negative.43. the holding cost is the cost of financing plus cost of storage and insurance purchased. annually or semiannually.43.
(6. If F < S(1 + r)T or F > S(1 + r)T.2 The cost of carry model T Time till expiration
Whenever the futures price moves away from the fair value. the logic for pricing a futures contract is exactly the same as the logic for pricing a forward contract.Rs. At the end of three months.
in the process making a net gain of Rs. An arbitrager can short one share for Rs. there exists arbitrage.80
365 = Rs. Under such a situation. if the one-month contract was for a 100 kgs of gold instead of 10 gms.40. However.7000/ 10 gms.7263. Warehouse charges include
. The proceeds of the short sale grow to 40e − 40. eventually driving the forward price down to Rs. Suppose that the forward price is relatively low at Rs.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.15 × 30
would increase the futures price. At the end of the three months. In this case the fair value of the futures. the futures price would be F = 7000e Rs.40. The same arguments hold good for a futures contract on an investment asset. arbitragers will sell the asset in the forward market. and take a long position in a three-month forward contract.50 in three months. works out to be = Rs. At a forward price of Rs. Similarly if the forward price is less than Rs. This is the fair value of the forward contract.1 gives the indicative warehouse charges for accredited warehouses/ vaults that will function as delivery centres for contracts that trade on the NCDEX.40.7000/ 10 gms.15 × 30 365
3. Let us first try to work out the components of the cost-of-carry model. 7086. What is the cost of financing for a month? e
0. the gold contract was for 10 grams of gold.80 plus the holding costs. S= Rs.50. there exists arbitrage.40.15 ×
6.50 at the end of three months.05 × 0.7086. The spot price of gold is Rs.80
Pricing commodity futures
2. invest the proceeds of the short sale at 5% per annum for three months.40. eventually pushing the forward price up to Rs. Table 6. 1. What is the spot price of gold? The spot price of gold. Let us take the example of a futures contract on a commodity and work out the price of the contract. then it would involve non-zero holding costs which would include storage and insurance costs. Arbitragers will buy the asset in the forward market. Hence we ignored the storage costs. takes delivery of the share under the terms of the forward contract and uses it to close his short position. the arbitrager pays Rs.50.
0. What are the holding costs? Let us assume that the storage cost = 0. expiring on 30th March.40.e. 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 2004.39. the cost of financing 0.25
We see that if the forward price is greater than Rs.
2. If the cost of financing is 15% annually.2. 1. In the example we considered.50.80 F = Se rT = 7000e If the contract was for a three-month period i.39.7086. 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. The price of the futures contract would then be Rs.75
0.50. Now let us try to extend this logic to a futures contract on a commodity. Therefore.50 there will be no arbitrage.
the futures price of a commodity that is an investment asset is given by F = SerT Storage costs add to the cost of carry.6000 per 10 grams and the risk-free rate is 7% per annum.4)
. However. At one point. 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. on October 19. the highlight of the whole episode was the fact that inspite of huge losses. 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.2 The cost of carry model 8 1 Under normal market conditions.1987. it costs Rs.3170 to store one kg of gold for a year(52 weeks). 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. the US market saw a breakdown in this classic relationship between spot and futures prices. The per unit charges include storage costs and insurance charges.1987. the New York Stock Exchange placed temporary restrictions on the way in which program trading could be done.55 per week. The result was that the breakdown of the traditional linkages between stock indexes and stock futures continued. 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. F. Assume further that the spot gold price is Rs. and the variable storage costs are Rs.76 (S + U)erT (6. For most of the day. If U is the present value of all the storage costs that will be incurred during the life of a futures contract. What would the price of one year gold futures be if the delivery unit is one kg? F = (S+ U)erT = (600000 + 310 + 2860)e0.6. futures traded at significant discount to the underlying index. Suppose the fixed charge is Rs. there were no defaults by futures traders. October 20. Assume that the payment is made at the beginning of the year.07 x 1 = 646904.310 per deposit upto 500 kgs. On the next day. the futures price is very close to S(X + r)T. This was largely because delays in processing orders to sell equity made index arbitrage too risky.1987
a fixed charge per deposit of commodity into the warehouse.9: The market crash of October 19. and a per unit per week charge. Box 6.
46.11. What would the price of three month gold futures if the delivery unit is one kg?
F = (S + U)erT = (600000 + 310 + 715)e0.6469. We make the same assumptions the fixed charge is Rs. Now let us consider a three-month futures contract on gold. the arbitrage arguments used to determine futures prices need to be reviewed carefully. Assume that the storage costs are paid at the time of deposit. It costs Rs.) Gold Silver Soy Bean Soya oil Mustard seed Mustard oil RBD Palmolein CPO Cotton .indicative warehouse charges Commodity Fixed charges Warehouse charges per unit per week (Rs. Suppose we have F > (S+U)erT (6.2 Pricing futures contracts on consumption commodities
We used the arbitrage argument to price futures on investment commodities.310 per deposit upto 500 kgs.6.82
Pricing commodity futures
Table 6. Assume further that the spot gold price is Rs.1025 to store one kg of gold for three months(13 weeks).) (Rs.55 per week.2. For commodities mat are consumption commodities rather than investment assets. an arbitrager can implement the following strategy:
6.1 NCDEX .635.6116.long Cotton .50. The threemonth futures price for 10 grams of gold would be about Rs.6.07 x
0. The one-year futures price for 10 grams of gold would be about Rs.5)
To take advantage of this opportunity.50
We see that the three-month futures price of a kg of gold would be Rs.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. and the variable storage costs are Rs.6000 per 10 grams and the risk-free rate is 7% per annum.
do so. When they observe the inequality in equation 6. Suppose next that (S+U)erT
(6. because of its consumption value . this strategy leads to a profit of F . many investors hold the commodity purely for investment. 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. for commodities like cotton or wheat that are held for consumption purpose.F relative to the position that the investors would have been in had they held the underlying commodity.5 does not hold good. However. F<=(S+U) erT That is the futures price is less than or equal to the spot price plus the cost of carry. they will find it profitable to trade in the following manner:
1.6. and invest the proceeds at the risk-free interest rate. As arbitragers exploit this opportunity.
6.6 does not hold good. save the storage costs. We see that as a futures contract nears expiration. the spot price will decrease and the futures price will increase until equation 6.6)
In case of investment assets such as gold and silver.(S + U) erT at the expiration of the futures contract. the basis reduces to zero. Sell the commodity. Take a long position in a forward contract.3 The futures basis
1. Individuals and companies who keep such a commodity in inventory. The difference between the spot price and the futures price is called the basis. Therefore there is unlikely to be arbitrage when equation 6. This happens because if the futures price is above the spot price during the delivery period it gives rise to a clear arbitrage
. This means that there is a convergence of the futures price to the price of the underlying asset. for a consumption commodity therefore.3 The futures basis
The cost-of-carry model explicitly defines the relationship between the futures price and the related spot price. Short a forward contract on one unit of the commodity.6.4 holds good.
2. In short. They are reluctant to sell these commodities and buy forward or futures contracts because these contracts cannot be consumed. This means that for investment assets.not because of its value as an investment. equation 6.6 holds good.
If we regard the futures contract as a forward contract. As arbitragers exploit this opportunity. 2. This would result in a profit at maturity of (S + U) erT . the spot price will increase and the futures price will decrease until Equation 6. this argument cannot be used.
the basis reduces. In the case of consumption assets.
• As the date of expiration comes near. 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. the basis is zero.there is a convergence of the futures price towards the spot price(Figure 6.1 Variation of basis over time
Pricing commodity futures
The figure shows how basis changes over time.
. This will lead to a profit equal to the difference between the futures price and spot price. As traders start exploiting this arbitrage opportunity the demand for the contract will increase and futures prices will fall leading to the convergence of the future price with the spot price. • There is nothing but cost-of-carry related arbitrage that drives the behaviour of the futures price in the case of investment assets.
opportunity for traders. In case of such arbitrage the trader can short his futures contract. At a later stage we shall look at how these arbitrage opportunities can be exploited. 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. we need to factor in the benefit provided by holding the physical commodity.1).
• Transactions costs are very important in the business of arbitrage. Towards the close of trading on the day of settlement. On the date of expiration. then there is an arbitrage opportunity.84 Figure 6. If it is not. 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. If the futures price is below the spot price during the delivery period all parties interested in buying the asset will take a long position. the basis reduces . The closing price for the April gold futures contract is the closing value of gold in the spot market on that day. buy the asset from the spot market and make the delivery. As the time to expiration of a contract reduces. the futures price and the spot price converge.
1. Q: As the a futures contract nears expiration. 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.6. Most investors 4. Q: An investment asset is an asset that is held for consumption purposes by 1. and warehousing cost are Rs.a. 3. 6025. Q: An investment asset is an asset that is held for investment purposes by 1. All investors 3.3 The futures basis
Note: The pricing models discussed in this chapter give an approximate idea about the true future price. 6075. All investors 3. Time-value ••
Q: What is the fair value of one month futures if the spot value of gold is Rs. Most investors 4. 6050.40. Large investors 2. Miller 4. Remains unchanged 4. Black & Scholes 2. Some investors A: The correct answer is number 3. 3. Cost-of-carry A: The correct answer is number 2. 6090.25 1.•
A: The fair value is 6025e01x00833 = 6075.00 2. Reduces A: The correct answer is number 2. Increases 2.40 3. Large investors 2.6000 per 10 grams? The money can be invested at 10% p. the basis 1.
Q: The _______ model is used for pricing futures contracts. Some investors A: The correct answer is number 3. The correct answer is number 2. Reduces to half
.30 .00 4.
Selling futures 2. Buying the underlying asset 3. Selling futures 2. Selling the underlying asset and buying futures •• set 4. Q: When the futures price happens to be lower than the fair value of the futures contract. Selling the underlying asset and buying futures
3. arbitragers profit by 1. ••
. Selling futures and buying the underlying asA: The correct answer is number 3. Buying the underlying asset set 4. arbitragers profit by 1. Selling futures and buying the underlying asA: The correct answer is number 4.86
Pricing commodity futures
Q: When the futures price happens to be higher than the fair value of the futures contract.
7.000 for each 1 rupee decrease in the price during this period. who are influenced by the commodity prices. Hedgers could be government institutions. extractors. that it makes the outcome more certain.Chapter 7 Using commodity futures
For a market to succeed. it must have all three kinds of participants .00. To hedge. he obtains a hedge by locking in to a predetermined price. Take the case of a company that knows that it will gain Rs. processors etc. the company should take a short futures position that is designed to offset this risk. 1. ginners. 1. In this chapter we look at the use of commodity derivatives for hedging.
Basic principles of hedging
When an individual or a company decides to use the futures markets to hedge a risk. trading companies and even other participants in the value chain. Commodity markets give opportunity for all three kinds of participants. the gain on the futures position offsets the loss on the commodity.1
Many participants in the commodity futures market are hedgers.00.00. for instance farmers. 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. This risk might relate to the price of wheat or oil or any other commodity that the person deals in. it could make the outcome worse..00. the objective is to take a position that neutralises the risk as much as possible.000 for each 1 rupee increase in the price of a commodity over the next three months and will lose Rs. speculation and arbitrage. They use the futures market to reduce a particular risk that they face. The futures position should lead to a loss of Rs.000 for each 1 rupee decrease in the price of a commodity over the same period. private corporations like financial institutions. 1.1.hedgers. speculators and arbitragers. 1. By selling his crop forward. Hedging does not necessarily improve the financial outcome. What it does however is. If the price of the commodity goes down.000 for each 1 rupee increase in the price of the commodity over the next three months and a gain of Rs. If
. The confluence of these participants ensures liquidity and efficient price discovery on the market. indeed.
by going in for a short hedge he locks on to a price of Rs. 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. Similarly. This is known as long hedge.1. Let a look at a more detailed example to illustrate a short hedge. This is called a short hedge. A short futures position will give him the hedge he desires. 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. We will study these two hedges in detail. A company that wants to sell an asset at a particular time in the future can hedge by taking short futures position. As we said.450 per MT.2 Short hedge
A short hedge is a hedge that requires a short position in futures contracts. For example. a company that knows that it is due to buy an asset in the future can hedge by taking long futures position.
7.88 Figure 7. the loss on the futures position is offset by the gain on the commodity. or is likely to own the asset and expects to sell it at some time in the future. 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. a short hedge is appropriate when the hedger already owns the asset. Irrespective of what the spot price of soy oil is three months later. We assume that today is the
. For example.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.
the price of the commodity goes up. an exporter who knows that he or she will receive a dollar payment three months later.
1. 10000 for each one rupee decrease in the price of oil during this period.10 per 10 Kgs.7. 10. A firm involved in industrial fabrication knows that it will require 300 kgs of silver on April 15 to meet a certain contract.10 per 10 Kgs.450 per 10 Kgs and the April soy oil futures price on the NCDEX is Rs.455. Case 2: The spot price is Rs.475 per 10 Kgs. The company realises Rs.4. The company realises Rs. The oil producer is therefore in a position where he will gain Rs. the effect of the strategy would be to lock in a price close to Rs.4.65. Rs.455 per 10 Kgs.1 gives the soy oil futures contract specification.000 in total.1 gives the payoff for a short hedge.465 per 10 Kgs. per 10 Kgs Tick size 5paisa Trading hours
15th of January and that a refined soy oil producer has just negotiated a contract to sell 10.000 in total.1 Hedging Table 7.465 .10. 1. Let us look at how this works. making a loss of Rs.4. making a gain of Rs.465 = Rs.455 = Rs. The company closes its short futures position at Rs. or Rs.4.000 under its sales contract.55. On April 15.475 on that date. Figure 7.10:00 am to 4:00 pm Closing session .75.
7. Suppose the spot price for soy oil on January 15 is Rs. 1680
.465 per 10 Kgs. the futures price on April 15 should be very close to the spot price of Rs. The company closes its short futures position at Rs. The total amount realised from both the futures position and the sales contract is therefore about Rs.000 on its short futures position.000 under its sales contract. The producer can hedge his exposure by selling 10. The spot price of silver is Rs.000 Kgs worth of April futures contracts (10 units). 2.465 or below Rs.4:15 pm to 4:30 pm Unit of trading 1000 Kgs (=1 MT) Delivery unit 10000 Kgs (=10 MT) Quotation/ base value Rs. Case 1: The spot price is Rs. Because April is the delivery month for the futures contract. Table 7.465 per 10 Kgs.000 on its short futures position.3 Long hedge
Hedges that involve taking a long position in a futures contract are known as long hedges. or Rs. Suppose that it is now January 15.1 Refined soy oil futures contract specification Trading system NCDEX trading system Monday to Friday Normal market hours . 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. the spot price can either be above Rs.465.000 Kgs of soy oil.465 per 10 Kgs.65.475 .Rs. It has been agreed that the price that will apply in the contract is the market price on the 15th April. Rs.475.Rs. the futures price on April 15 should be very close to the spot price of Rs.455 on that date. If the oil producers closes his position on April 15. Because April is the delivery month for the futures contract. 10000 for each 1 rupee increase in the price of oil over the next three months and lose Rs. The total amount realised from both the futures position and the sales contract is therefore about Rs.
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
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.
• ∆ 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
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.
farmers producing small staple cotton could use the futures contract on medium staple cotton for hedging. or platinum as may be needed to make the products that will fill its orders. the hedger was able to identify the precise date in the future when an asset would be bought or sold. Hedges can be rolled forward many times. Often the hedge may require the futures contract to be closed out well before its expiration date. It is impractical for an exchange to have futures contracts with all these varieties of cotton as an underlying. hedging is not quite this simple and straightforward. in India we have a large number of varieties of cotton being cultivated.1. a jewelry manufacturer can determine the
cost for gold.
7.7. In reality. The hedger was able to identify the precise date in the future when an asset would be bought or sold. The loss made during selling of an asset may not always be equal to the profits made by taking a short futures position. the hedge would not be perfect. 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. a merchandiser with a large. since the price of the farmers cotton and the price of the cotton underlying the futures contract do match perfectly.6 Limitation of hedging: basis Risk
In the examples we used above. long staple cotton and medium staple cotton. Hedging permits forward pricing of products.
3. In our examples. This could result in an imperfect hedge. silver. the hedges considered were perfect. • The hedger may be uncertain as to the exact date when the asset will be bought or sold. But in many cases. When this
happens. even if the price of the commodity drops. However. Hedging protects inventory values. this may not always be possible for a various reasons. Having made the forward sales. For example. Hedging can only minimise the risk but cannot fully eliminate it. This is called a rollover. 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 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. unsold inventory can sell futures contracts that will protect the value of the inventory. For example.1 Hedging
• The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract. and make forward sales to stores at firm prices. While this would still provide the farmer with a hedge. he would get a better hedge. In reality. For example. 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. 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.
. If a hedger has an underlying asset that is exactly the same as the one that underlies the futures contract.
• The expiration date of the hedge may be later than the delivery date of the futures contract. translate that to a price for the finished products. This is called the basis risk. the manufacturer can use his capital to acquire only as much gold.
We look here at how the commodity futures markets can be used for speculation. This enables futures traders to take a position in the underlying commodity without having to to actually hold that commodity. However. he would have to buy gold and hold on to it.
7. it is easy to buy the shares and hold them for whatever duration he wants to.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 .6000 per 10 gms in the spot market and he expects its price to go up in the next two-three months.6000 per 10 gms and three-month gold futures trades at Rs.000 for a period of three months. With the purchase of futures contract on a commodity. Suppose further that his hunch proves correct and three months later gold trades at Rs.1
Speculation: Bullish commodity. Perhaps he knows that towards the end of the year due to festivals and the upcoming wedding season. commodities are bulky products and come with all the costs and procedures of handling these products. Gold trades at Rs.6. 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). Gold trades for Rs.000. Today a speculator can take exactly the same position on gold by using gold futures contracts.6150.10:00 am to 4:00 pm Closing session . a customer must open a futures trading account with a commodity derivatives broker.94
Table 7.per 10 gms of gold with 999 fineness 5paisa
7. This works out to an annual return of about 26 percent.2.00. Suppose he buys a 1 kg of gold which costs him Rs.6.00. the prices of gold are likely to rise.40. He makes a profit of Rs.000 on an investment of Rs.3 gives the contract specifications for gold futures. Let us see how this works. The unit of trading
. Buying futures simply involves putting in the margin money. He would like to trade based on this view. While the basics of speculation apply to any market.2 Speculation
An entity having an opinion on the price movements of a given commodity can speculate using the commodity market.6400 per 10 grms. buy futures
Take the case of a speculator who has a view on the direction of the price movements of gold.4:15 pm to 4:30 pm 100 gm 1kg Rs. How can he trade based on this belief? In the absence of a deferral product. To trade commodity futures on the NCDEX. Table 7. The commodities futures markets provide speculators with an easy mechanism to speculate on the price of underlying commodities. 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.
000.6400 in the process making a profit of Rs. there will be operators who will buy in the market where the asset sells cheap and sell in the market where it is costly. commodity futures form an attractive tool for speculators. How can he trade based on this opinion? In the absence of a deferral product.00.8)
A central idea in modern economics is the law of one price. if his hunch were correct the price of cotton falls.6400 per 10 gms.000. Now take the case of the trader who expects to see a fall in the price of cotton. He buys one kg of gold futures which have a value of Rs. This activity termed as arbitrage.50.20. if two assets are equivalent from the point of view of risk and return. He pays a small margin on the same. Today all he needs to do is sell commodity futures. arbitrage helps to equalise prices and restore market efficiency. He sells ten two-month cotton futures contract which is for delivery of 550 bales of cotton.1. there wasn't much he could do to profit from his opinion.25. so will the futures price.000.
7.15.1.000. so will the futures price.6.2 Speculation: Bearish commodity. To take this position. So does the price of cotton futures.000. he pays a margin of Rs. As we know. He closes his long futures position at Rs. making a profit of Rs. If the commodity price rises. involves the simultaneous purchase and sale of the same or essentially similar security in two different markets for advantageously different prices. Buying an asset in the futures market only require making margin payments.7. Three months later.50.3 Arbitrage
is 100 gms and the delivery unit for the gold futures contract on the NCDEX is 1 kg.000. He close out his short futures position at Rs.2.
7. If the commodity price falls. This works out to an annual return of 83 percent. the futures price converges to the spot price (else there would be a risk-free arbitrage opportunity). on the day of expiration.000 on an initial margin investment of Rs.3. Hence. If the price of the same asset is different in two markets.20. Because of the leverage they provide. Simple arbitrage ensures that the price of a futures contract on a commodity moves correspondingly with the price of the underlying commodity.
F = where:
r Cost of financing (annualised) T Time till expiration
(7. they should sell at the same price. Three months later gold trades at Rs. Let us understand how this works.4. The value of the contract is Rs. 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. This states that in a competitive market. The buying cheap and selling expensive continues till prices in the two markets reach an equilibrium.
51.000.55 per kg per week for 13 weeks).50. buying the spot and holding it or selling the spot and investing the proceeds.07.8 gives the fair value of a futures contract on an investment commodity. even if there exists a mispricing. return the borrowed amount plus interest of Rs. The result is a riskless profit of Rs.50. the arbitrager must sell spot and buy futures.000. in the case of consumption assets which are held primarily for reasons of usage. sell futures
An arbitrager notices that gold futures seem overpriced. He could make riskless profit by entering into the following set of transactions.00. In the case of investment commodities. whereas to capture mispricings that result in underpriced futures. Take delivery of the gold purchased and hold it for three months. Pay (310 + 7150) as warehouse costs. On the futures expiration date.60.62.310 per deposit upto 500 kgs. it makes sense to arbitrage. This is termed as cash-and-carry arbitrage. To capture mispricings that result in overpriced futures.000. (We assume that fixed charge is Rs. one has to build in the transactions costs into the arbitrage strategy. gold trades for Rs. we discussed that the cost-of-carry ensures that futures prices stay in tune with the spot prices of the underlying assets. sell 10 gold futures contract at Rs. 1. Equation 7. On day one. However.50. Now unwind the position.600 per gram in the spot market.98.
8. Three month gold futures on the NCDEX trade at Rs.3. How can he cash in on this opportunity to earn riskless profits? Say for instance.00. 7. 3. a person who holds the underlying may not want to sell it to profit from the arbitrage.
1.000 held in hand. mispricing would result in both. Simultaneously. 5. the spot and the futures price converge.62. 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. Remember however.61. and the variable storage costs are Rs. the arbitrager must sell futures and buy spot.460 at 6% per annum to cover the cost of buying and holding gold.615 in the spot market.96 U Present value of all storage costs
Using commodity futures
In the chapter on pricing. 4.60. arbitrage opportunities arise. Sell the gold for Rs. 2.000. Say gold closes at Rs. borrow Rs.60. From the Rs.749.251. 6.1
Overpriced commodity futures: buy spot. Whenever the futures price deviates substantially from its fair value. Buy 10 kgs of gold on the cash/ spot market at Rs. Futures position expires with profit of Rs.1. In the real world.
7.625 and seem overpriced. that exploiting an arbitrage opportunity involves trading on the spot and futures market.
buy silver futures 2.00. sell mustard seed A: The correct answer is number 1. buy mustard seed futures 2. 2.50. The result is a riskless profit of Rs.000.60.3 Arbitrage
7.61. sell index futures ••
.7. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost-of-carry. If he happens to hold gold. 8. 1. The gold sales proceeds grow to Rs. gold trades for Rs. it makes sense for you to arbitrage.47.615 per gram.50. 6. we will see increased volumes and lower spreads in both the cash as well as the derivatives market. 3. Suppose the price of gold is Rs.00. sell spot
An arbitrager notices that gold futures seem underpriced. sell silver futures 4.
1. Invest the Rs. buy silver A: The correct answer is number 3. 4.000 plus the Rs. buy three-month gold futures on NCDEX at Rs.605 and seem underpriced. he could make riskless profit by entering into the following set of transactions.00. 5.
If the returns you get by investing in riskless instruments is more than the return from the arbitrage trades. Simultaneously.000. He should _ 1.60. Buy back gold at Rs. 3.7150 saved by way of warehouse costs for three months 6%. Now unwind the position.000 on the spot market.60.936.600 per gram in the spot market. exploiting arbitrage involves trading on the spot market. The futures position expires with a profit of Rs. This is termed as reverse-cash-and-carry arbitrage.3.97. Three month gold futures on the NCDEX trade at Rs.936.
Q: A speculator thinks that the price of mustard seed will rise. As we can see. 7.2 Underpriced commodity futures: buy futures. sell index futures •• 3. As more and more players in the market develop the knowledge and skills to do cash-and-carry and reverse cash-and-carry. How can he cash in on this opportunity to earn riskless profits? Say for instance.60. sell 10 kgs of gold in the spot market at Rs.000. On the futures expiration date. the spot and the futures price of gold converge. On day one. sell mustard seed futures 4. He should _ 1. Q: A speculator thinks that the price of silver will fall.
The spot price for soy oil on January 15 is Rs. buying wheat futures 2. Expects to own the underlying asset in the ture 4. Wants to buy the underlying asset in the fufuture.465 per 10 Kgs. 2. 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.000 Kgs of soy oil.
A: The producer needs to take a short hedge to the extent of 10. selling wheat futures A: The correct answer is number 2. None of the above A: The correct answer is number 2. One trading unit is for 1000 Kgs of soy oil. Wants to buy the underlying asset in the futoday.98 Q: A long hedge should be taken by a person who 1. 3.
Using commodity futures
3. He gets the hedge by selling 10 units of April futures.
. 3. 2. buying index futures 4. It has been agreed that the price that will apply in the contract is the market price on the 15th April. Selling 10 units of April futures. Buying 100 units of April futures. Wants to sell the underlying asset
2. The correct answer is number 1. None of the above ••
Q: A short hedge should be taken by a person who 1. ••
Q: A farmer who has just sown wheat can hedge his position by _ 1. 4. The producer can hedge his exposure by 1.000 Kgs of soy oil. 4. ture.450 per 10 Kgs and the April soy oil futures price on the NCDEX is Rs. Sell the underlying asset in the future A: The correct answer is number 1. 3. selling the wheat ••
Q: On the 15th of January a refined soy oil producer has negotiated a contract to sell 10. Selling 100 units of April futures. Buying 10 units of April futures.
A unit of trading is 5 Kgs and the delivery unit is 30 Kgs.
Q: A company knows that it will require 33.250 per 10 gms. The unit of trading is 11 bales and the delivery unit for cotton on the NCDEX is 55 bales. The correct answer is number 3. He gets the hedge by selling 60 units of April silver futures.500 3. Buying 60 units of April silver futures.000
A: One unit of trading is 100 gms. Buying 2550 units of three-month cotton tures. 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.
A: One trading unit is for 11 bales of cotton.000 bales of cotton in three months. The correct answer is 10 number 3.6000 per 10 gms in the spot market. • •
A: The fabricator needs to take a long hedge to the extent of 300 kgs of silver. His total profit from the position 1000. Selling 30 units of April silver futures. The company can obtain a hedge by 1. 4. He makes a profit/loss of 1.000 4. The correct answer is number 2. 1730.000 × 0. Selling 600 units of three-month cotton tures.7. 11
Q: Gold trades at Rs. 3. Three-month gold futures trade at Rs. He is long 10 units of futures.85. (-)2. 2. Selling 2550 units of three-month cotton fufutures. The spot price of silver is Rs. 4. (-)25. (+)25. The hedge ratio works out to be 0. or 1000 grms of gold. The fabricator can hedge his position by 1. He makes 250 a profit of Rs. Selling 60 units of April silver futures. Buying 30 units of April silver futures. One trading unit is for 5 Kgs of silver. A speculator who expects gold prices to rise in the near future buys 10 units of gold futures.85.6150. (+)2. 3.500 2.1680 per kg and the April silver futures price is Rs.3 Arbitrage
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.85 units of futures. The hedge ratio is 0. Two months later gold futures trade at Rs. 2. Buying 2550 units of three-month cotton fufutures. The company obtains a hedge by Buying
000 4. A speculator who expects gold prices to fall in the near future sells 10 units of gold futures. One unit of trading is 100 gms and the delivery unit for the gold futures contract on the NCDEX is 1 kg.
150 × 1000.6150. Three-month gold futures trade at Rs. Two months later gold futures trade at Rs.500 3. or 1000 grms of gold.500 2.6000 per 10 gms.000
A: One unit of trading is 100 gms. He makes a profit/loss of 1. He makes a profit of Rs.150 per 10 gms. He is short 10 units of futures. (+)1.100
Using commodity futures
Q: Gold trades at Rs. (-)1. His total profit from the position is number 4. The correct answer is 10
. (-)15. (+)15.6000 per 10 gms in the spot market.
After hours trading has also been proposed for implementation at a later stage. The number of users allowed for each trading member is notified by the exchange from time to time. time and quantity.
8. All quantity fields are in units and price in rupees. When any order enters the trading system. the order becomes passive and gets queued in the respective outstanding order book in the system. Order matching is essentially on the basis of commodity.trading cum clearing members and professional clearing members. 1.
. Trading cum clearing members (TCMs): Trading cum clearing members are members of NCDEX. a trade is generated. The exchange assigns an ID to each TCM. If it does not find a match.
8.2 Entities in the trading system
There are two entities in the trading system of NCDEX .1 Futures trading system
The trading system on the NCDEX. where orders match automatically.00 p.m.
They can trade and clear either on their own account or on behalf of their clients including participants. to 4. If it finds a match. The exchange notifies the regular lot size and tick size for each of the contracts traded from time to time. It tries to find a match on the other side of the book. its price.Chapter 8 Trading
In this chapter we shall take a brief look at the trading system for futures on NCDEX. Time stamping is done for each trade and provides the possibility for a complete audit trail if required.00 a. The exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities . provides a fully automated screen-based trading for futures on commodities on a nationwide basis as well as an online monitoring and surveillance mechanism. 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. The trade timings on the NCDEX are 10. The NCDEX system supports an order driven market.m. it is an active order. However. Each TCM can have more than one user.
2. 2. In some cases.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 PCM membership entitles the members to clear trades executed through Trading cum Clearing Members (TCMs). This ID is common for all users of a particular TCM.
8. Once filled. The same client should not be allotted multiple codes.2. A unique client code is to be allotted for each client. who bid on the order using hand signals. Box 8. The client code should be alphanumeric and no special characters can be used. To place an order under this method. In open outcry system the futures contracts are traded in pits. negotiates a price by shouting out the order to other floor traders. All clients trading through a member are to be registered clients at the member's back office. 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 brokers. Each side of the octagon forms a pie slice in the pit. who time-stamps the order and prepares an office order ticket. standing in a central location i.
3. The floor trader. It is the responsibility of the TCM to maintain adequate control over persons having access to the firm's User IDs. trading pit. 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. Large orders typically go directly from the customer to the broker's floor booth. both for themselves and/ or on behalf of their clients. At the end of each day. The unique TCM ID functions as a reference for all orders/ trades of different users. the order is recorded manually by both parties in the trade. There. Professional clearing members: Professional clearing members are members of NSCCL.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. Live Cattle pit etc. Normally only one type of contract is traded in each pit like a Eurodollar pit. 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. some still follow the open outcry method. the floor clerk may use hand signals to convey the order to floor traders. a floor order ticket is prepared. The broker then sends the order to a booth on the exchange floor called broker's floor booth.102
While most exchanges the world over are moving towards the electronic form of trading. the clearing house settles trades by ensuring that no discrepancy exists in the matched-trade information. 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. and a clerk hand delivers the order to the floor trader for execution. the customer calls a broker. Open outcry trading is a face—to-face and highly activate form of trading used on the floors of the exchanges.e.
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. In the first phase. If the 20th of the expiry month is a trading holiday. copper. New contracts will be introduced on the trading day following the expiry of the near month contract. trading has commenced in cotton (long and medium staple). soya oil. zinc and nickel) and commodity indices like agri commodity index and metal commodity index. coffee.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. rape/ mustard oil. sunflower.3 Contract specifications for commodity futures
Table 8.8. S06 L S Cotton Ahmedabad
GLDPURMUM SLVPURDEL SYBEANIDR SYOREFTDR RMSEEDJPR RMOEXPJPR RBDPLNKAK CRDPOLKDL COTJ34BTD COTS06ABD
8. Soybean Indore 4. the contracts shall expire on the previous trading day. it has already started trading in gold and silver. soybean. Crude Palm Oil Kandla 9.2 and Table 8. base metals (aluminium. edible oil products like groundnut. Rapeseed Mustard Seed Jaipur 6. castor (seed. Expeller Rapeseed Mustard Oil Jaipur 7. Pure Gold Mumbai 2. All contracts expire on the 20th of the expiry month. Table 8.1 gives the list and symbols of underlying commodities on which futures contracts are available. J34 Medium Staple Cotton Bhatinda 10. two-month and three-month expiry cycles. crude palm oil and RBD palmolein.1 Commodity futures contract and their symbols 1. Pure Silver New Delhi 3. tea.4 Commodity futures trading cycle
NCDEX trades commodity futures contracts having one-month. rape/ mustardseed.3 give the futures contract specifications for gold and long staple cotton.
8.1 shows the contract cycle for futures contracts on NCDEX. and in agri commodities. under the category of bullion. Refined Soya Oil Indore 5.
. In the second phase NCDEX plans to offer the following commodities for trading .rice. wheat. RBD Palm Olein Kakinada 8. oil and cake). Figure 8. Table 8.
January 2004 contract opens on 21st October 2003. 20th day of the delivery month. if 20th happens to be a holiday then previous working day.200 crore. Not less than 995 fineness bearing a serial number and identifying stamp of a refiner approved by NCDEX. 3 concurrent month contracts will be active. List of approved refiners will be available with the exchange and also on its web site: www. The settlement price for less than 999. There will be a total of twelve month contracts in a year.10:00 am to 4:00 pm Closing session . These conditions are broadly divided into the
.100 crore.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. 3 months prior to the contract month i.4:15 pm to 4:30 pm 100 gms lKg Rs. Member-wise: Max (Rs.2 Gold futures contract specification Trading system Trading hours NCDEX trading system Monday to Friday Normal market hours . 10% of Open interest) The discount will be given for the fineness below 999. Mumbai Trading in any contract month will open on the 21st day of the month.9.e. per 10 gms of Gold with 999.9 fineness will be calculated as: (Actual fineness/ 999.9 fineness (called "Pure Gold" in trade circles) 5 paisa Limit 10%.ncdex. 15% of open interest) Client-wise: Max (Rs. of active contracts
Delivery center Opening date
Position limits Premium/ Discount
8.com None At any date.9) * Settlement price
Unit of trading Delivery unit Quotation/ base value Tick size Price band Quality specification
Quantity variation No.104
Table 8. Limits will not apply if the limit is reached during final 30 minutes of trading.
Member-wise: Max (Rs. There will be a total of twelve month contracts in a year.2) Strength.3 Long staple cotton futures contract specification Trading system Trading hours NCDEX trading system Monday to Friday Normal market hours .20 crore. January 2004 contract opens on 21st October 2003.5 At any date.40 crore. Ahmedabad Trading in any contract month will open on the 21st day of the month. (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). 'Fine'. if 20th happens to be a holiday then previous working day. % Max: 8. 10% of Open interest) Will be given on the basis of Staple Length (at 0.5 (Basis: 3. 'Superfine'. 3 concurrent month contracts will be active.5 mm intervals) & grade combinations.
Unit of trading Delivery unit Quotation/ base value Tick size Price band Quality specification
No.7 Quintal (=11 bales) 93. 15% of open interest) Client-wise: Max (Rs.10:00 am to 4:00 pm Closing session .5 Order types and trading parameters
Table 8.4-4. per Quintal 5paisa Limit 10%.4:15 pm to 4:30 pm 18. Limits will not apply if the limit is reached during final 30 minutes of trading. of active contracts
Delivery center Opening date
Position limits Premium/ Discount
.5 Quintals (=55 bales) Rs. 'Fully Good'. Main/ Base Variety: Shankar-6 Staple Length: 27-30 mm (Basis: 29 mm) Micronaire: 3. 'Extra Superfine'.7-4.e. 3 months prior to the contract month i. Min: 21 G/ Tex Grade: 'Good to Fully Good'. Moisture.8. The exchange will communicate the premium/ discounts applicable before the settlement date. 20th day of the delivery month.
341 and closes.Good till cancelled (GTC): A GTC order remains in the system until the user cancels it. The days counted are inclusive of the day on which the order is
. it spans trading days. if not traded on the day the order is entered. one has to place the order again the next day. a middle-month and a farmonth. immediate or cancel order. the order types available on the NCDEX system are regular lot order. Of these. good till date order and spread order. If the market does not reach this price the order does not get filled even if the market touches Rs. • Time conditions
. If the order is not executed during the day. As can be seen.
. In other words day order is for a specific price and if the order does not get filled that day. good till cancelled order.340/ 10 kg. good till day order.
• Time conditions • Price conditions • Other conditions
Several combinations of the above are possible thereby providing enormous flexibility to users. As the January contract expires on the 20th of the month.Good till day order: A day order. 2004 in refined palm oil on the commodity exchange. as the name suggests is an order which is valid for the day on which it is entered. stop loss order. at any given point of time.a near-month.1 Contract cycle
The figure shows the contract cycle for futures contracts on NCDEX. A day order is placed at Rs. 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. three contracts are available for trading . Example: A trader wants to go long on March 1. The order types and conditions are summarised below. once more making available three index futures contracts for trading. a new three-month contract starts trading from the following day. the system cancels the order automatically at the end of the day.106 Figure 8.
Consequently. Each day counted is a calendar day inclusive of holidays.
Example: A trader wants to go long on refined palm oil when the market touches Rs. stop order gets executed and the trader would exit the market. failing which the order is cancelled from the system. For the stop-loss sell order. The order gets filled at the suggested stop order price or at a better price. price is market price). Unlike a fill-or-kill order. it gets cancelled. 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. He wishes to limit his loss to Rs. 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. stop orders can be executed for buying/ selling positions too. Example: A trader has purchased crude oil futures at Rs. if obtainable at the time of execution. • Price condition .750 per barrel. . to buy or sell a particular futures contract at the market price if and when the price reaches a specified level. The maximum days allowed by the system are the same as in GTC order. or not at all. which is to be executed in its entirety. . the system determines the price. The disadvantage is that the order may not get filled at all if the price for that day does not reach the specified price. and the unmatched portion of the order is cancelled immediately. it gets executed irrespective of the current market price of that particular asset. Only the position to be taken long/ short is stated. placed with the broker.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. • Other conditions . 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. the order is cancelled from the system. . But. When the price reaches that point the stop order becomes a market order. At the end of this day/ date.Stop-loss: A stop-loss order is an order.8.Limit order: An order to buy or sell a stated amount of a commodity at a specified price.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. An all-or-none order position can be closed out with another AON order.5 Order types and trading parameters
placed and the order is cancelled from the system at the end of the day of the expiry period. For such orders. stop orders are used to exit a trade.
. Theoritically. the order exists until it is filled up. or at a better price.Market price: Market orders are orders for which no price is specified at the time the order is entered (i. Stop orders are not executed until the price reaches the specified point.50 a barrel. When this kind of order is placed. the trigger price has to be greater than the limit price.e.400/ 10kg. even if it takes months for it to happen. A stop order would then be placed to sell an offsetting contract if the price falls to Rs 700 per barrel. When the market touches this price.All or none order: All or none order (AON) is a limit order. . an all-or-none order is not cancelled if it is not executed as soon as it is represented in the exchange. whichever is earlier. Most of the time. Partial match is possible for the 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.
900/ tonne.900/ tonne. The spreaders goal is to profit from a change in the difference between the two futures prices. This trade is also used to enter a new trade.900/ tonne.13. Box 8. An order placed so
as to take advantage of price movement. one long and one short. They are taken in the same commodity with different months (calendar spread) or in closely related commodities. The fill price will be within the closing range. The tick size in respect of all futures contracts admitted to dealings on the NCDEX is 5 paise. Prices of the two futures contract therefore tend to go up and down together. Example: A trader has a buy position at Rs. which may. .2 Tick size for contracts
The tick size is the smallest price change that can occur for the trades on the exchange. . Called Globex. be substantially different from the setdement price. 14. thereby closing the trade and at the same time.
. A stop order is placed at Rs.13.One cancels the other order : It is called one cancels the other order (OCO). Once one level is reached. The trader exits the market at Rs.5
8.1 Permitted lot size
The permitted trading lot size for the futures contracts on individual commodities is stipulated by the exchange from time to time. in some markets. which consists of both a stop and a limit price. .Spread order: A simple spread order involves two positions. 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.100/ tonne and a limit order at Rs.Market on close: The order will be executed on the market close. just so long as the futures contract he bought goes up more (or down less) than the futures contract he sold.000/ tonne on Soybean. The lot size currently applicable on individual commodity contracts is given in Table 8.5. and gains on one side of the spread are offset by losses on the other.11: After hours electronic trading system
. . cancelling the other entry order. or exit an open trade. This type of order would close the position if the market moved to either the stop rate or the limit rate. 14.
. one half of the order will be executed (either stop or limit) and the remaining order cancelled (either limit or stop).13.Limit price: Price of the orders after triggering from stop-loss book.5.
8.Market on open: The order will be executed on the market open within the opening range. Typically electronic trading systems are used in the open outcry exchanges after the day trading is over. This trade is used to enter a new trade. the limit order gets filled and the stop order is immediately gets cancelled. The trader is virtually unconcerned whether the entire price structure moves up or down. or exit an open trade.Trigger price: Price at which an order gets triggered from the stop-loss book. He wishes to have both stop and limit orders in order to fill the order in a particular price range.108
After-hours electronic trading first began in 1992 at CME (Chicago Mercantile Exchange). If the market trades at Rs.
5 Order types and trading parameters Table 8. Table 8. 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. The exchange can approve or
.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. Orders exceeding me range specified are not executed and he pending with the exchange as a price freeze.3 Quantity freeze
All orders placed by members have to be witiiin the quantity specified by the exchange in this regard.300 Bales
8.4 gives the quantity freeze for each commodity contract. not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of exposure limits. 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.5.4 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. in exceptional cases.5. In respect of orders which have come under price freeze.
8.8. 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.
8. These spot prices are polled across multiple centers and a single spot price is determined by the bootstrapping method.5. In respect of orders which have come under quantity freeze. the exchange can approve such order. the exchange may. On such confirmation.000 Grams (gm) 1. at its discretion.5 Price ranges of contracts
In order to prevent erroneous order entry by trading members. operating price ranges on the NCDEX are kept at +/.10% from the base price. 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. the base price is the previous days' closing price of the underlying commodity in the prevailing spot markets.300 Bales 3. However.
110 ___________________________________________________________________ Trading disapprove such orders solely at its own discretion. there will be no price ranges applicable in the last half hour of normal market trading. The function keys can be operated from the keyboard of the user. Unless specifically notified by the exchange.6 Order entry on the trading system
The NCDEX trading system has a set of function keys built into the trading front-end.
8. 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
. These keys have been provided to facilitate faster operation of the system and enable quicker trading on the system.5.
/ Quintal Rs./ 10 Kg Rs./ Quintal Rs./ 10 Kg Rs./ 10 GM Rs.5 Order types and trading parameters Table 8./ 10 Kg Rs.8./ 10 Kg Rs./Kg Rs./ Quintal
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
./20Kg Rs.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.
On the other hand. i. the funds can be withdrawn (those funds above the required initial margin) or can be used to fund additional trades. All futures contracts are settled daily reducing the credit exposure to one day's movement. • Additional margin: In case of sudden higher than expected volatility. This margin is meant to cover the largest potential loss in one day. the broker closes out the position by offsetting the contract. the margin account is adjusted to reflect the trader's gain or loss. which is somewhat lower than the initial margin. This is known as clearing margin.112
8. The margin required for a futures contract is better described as performance bond or good faith money. In the futures market. The margin levels are set by the exchanges based on volatility (market conditions) and can be changed at any time. • Maintenance margin: A trader is entitled to withdraw any balance in the margin account in excess of the initial margin. is set. Based on the settlement price. Clearing house and clearing house margins have been discussed further in detail under the chapter on clearing and settlement. which is a preemptive move to prevent breakdown. If the account falls below the maintenance margin level the trader needs to replenish the account by giving additional funds. To ensure that the balance in the margin account never becomes negative. We will discuss them in more details when we talk about risk management in the next chapter. The margin requirements for most futures contracts range from 2% to 15% of the value of the contract. If the balance in the margin account falls below the maintenance margin. At this stage we look at the types of margins as they apply on most futures exchanges.
Just as a trader is required to maintain a margin account with a broker. a maintenance margin. the accounts are either debited or credited based on how well the positions fared in that day's trading session. etc. a clearing house member is required to maintain a margin account with the clearing house. In the case of clearing house member. there is only an original margin and no maintenance margin. The margin is a mandatory requirement for parties who are entering into the contract. This is known as marking to market the account of each trader. • Mark-to-Market margin (MTM): At the end of each trading day. This is imposed when the exchange fears that the markets have become too volatile and may result in some payments crisis. If the trader does not provide the variation margin.e. The extra funds deposited are known as a variation margin. the exchange calls for an additional margin. the value of all positions is marked-to-market each day after the official close. 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.
• Initial margin: The amount that must be deposited by a customer at the time of entering into a contract is called initial margin. there are different types of margins that a trader has to maintain. if the position generates a gain.
.6 Margins for trading in futures
Margin is the deposit money that needs to be paid to buy or sell each contract.
1. 3. » » 3. The important provisions are listed below: The billing for the all trades done during the previous month will be raised in the succeeding month. 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. a penal
interest is levied as specified by the exchange. the billing details can be viewed on the website upto a maximum period of 12 months. A fully automated screen-based trading. Advance email intimation is also sent to the members. This Open interest figure is a good indicator of the liquidity in every contract.7 Charges
8. mechanism. Collection process: NCDEX has engaged the services of Bill Junction Payments Limited (BJPL) to collect the transaction charges through Electronic Clearing System.
Finally. BJPL sends the log-in ID and password to the mailing address as mentioned in the registration form. 5. Besides. members are required to remit Rs. This rate is subject to change from time to time. Trading on a nationwide basis. Penalty for delayed payments: If the transaction charges are not paid on or before the due date. The total number of outstanding contracts (long/ short) at any point in time is called the "Open interest".50. 2. the futures market is a zero sum game i.e. NCDEX then forwards the mandate form to BJPL.6 per Rs. Registration with BJPL and their services: Members have to fill up the mandate form and submit the same to NCDEX. 2. Trading by open-outcry
Q: The trading system on the NCDEX. Based on studies carried out in international exchanges.one Lakh trade done. Online monitoring and surveillance 4. 4.000 as advance transaction charges on registration. 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. Rate of charges: The transaction charges are payable at the rate of Rs. The members can then log on through the website of BJPL and view the billing amount and the due date. the total number of long in any contract always equals the total number of short in any contract.8. it is found that open interest is maximum in near month expiry contracts.7 Charges
Members are liable to pay transaction charges for the trade done through the exchange during the previous month. A: The correct answer is number 4.
6. Adjustment against advances transaction charges: In terms of the regulations. does not provide 1.
One-month 2. One week horizon A: The correct answer is number 1. Once every two weeks. Commodity 2. At the end of each day. Quantity 4. 2. At the end of each week. One month horizon ••
Q: NCDEX does not trade commodity futures contracts having __ expiry cycles 1. 3. Long staple cotton Ahmedabad A: The correct answer is number 2. 4. One day horizon 2. Medium staple cotton Bhatinda 2. Three-month 4. Six-month ••
Q: Billing to members for the all trades done on the NCDEX will be raised 1.114 ____________________________________________________________________ Trading Q: Order matching on the NCDEX happens on the basis of 1. A: The correct answer is number 2. 3. None of the above ••
Q: Initial margin is meant to cover the largest potential loss over a 1. In the succeeding month. One hour horizon 4. 3. ••
. 3. Small staple cotton Aurangabad 4. Two-month A: The correct answer is number 4. 3. Price and time A: Correct answer is number 4. All of the above ••
Q: COTS06ABD is the symbol for 1.
420 4. Rs. Rs.000 as part of his hedging strategy. 10
Q: A trader sells 20 units of gold futures at Rs.7.00.65. What is the value of his open long position? Unit of trading is 100 gms and delivery unit is one Kg 1.000 2.000 units
A: Futures price of 10 gms of gold is Rs. Unit of trading is 100 gms and delivery unit is one Kg. i. 10. 10. 100 units 3. What is the value of his open long position? Unit of trading is 100 gms and delivery unit is one Kg 1.7. He has bought 20 units. This means gold futures cost Rs. He has to buy 14 units of gold futures 700
contracts.500 per 10 gms. 10 units 2.700 per gram.57 gms of gold gms. Two month futures trade at Rs. The value of his long gold futures position is
7.e.100 per 10 gms. 20 units 3. Two month futures trade at Rs. The correct answer is number 4.200 3. The value of his long gold futures 5. Roughly how many units must he purchase to give him the hedge? 220.127.116.11.7 Charges
Q: A trader buys 10 units of gold futures at Rs.000 2. Rs.7. Rs. This means gold futures cost Rs.1. The correct answer is number 3.00.6. 1. 14.500 4.000
A: One trading unit is for 100 gms.65.000 as part of his hedging strategy.20.000
A: One trading unit is for 100 gms. 10
Q: A trader requires to take a long gold futures position worth Rs.6. He has bought 10 units.7.000 units 4. Rs.000.700 per gram.1. The correct answer is number 1. Unit of trading is 100 gms and delivery unit is one Kg. Rs.8.000 . The correct aanswer is number 1. He has to take a position
.7. Rs. 28 units
A: Futures price of 10 gms of gold is Rs.00. To take a position in 1000 gms of gold he has to buy 10 units of gold futures contracts. 14.000 3.000 per 10 gms.
Q: A trader requires to take a long gold futures position worth Rs. Rs. How many units must he purchase to give him the hedge? 1.000 per 10 gms. 10 units 2.50.500 position is × 100 × 10 . in 1428.100 × 100 × 20 .00.000. 14 units 4.
000 as part of his hedging strategy.000 units
A: Futures price of 10 gms of gold is Rs.000 units 4. The correct answer is number 1. Two month futures trade at Rs.7.000 per 10 gms. 10.116 ___________________________________________________________________ Trading Q: A trader requires to take a short gold futures position worth Rs. This means gold futures cost Rs.7. To take a position in 1000 gms of gold he has to sell 10 units of gold futures contracts. 10 units 2.00. How many units must he sell to give him the hedge? 1.000. Unit of trading is 100 gms and delivery unit is one Kg. 100 units 3. 1.7. ••
.700 per gram.
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. 3. Typically it is responsible for the following:
1. who are mostly financial institutions responsible for the clearing and settlement of commodities traded on the exchange. 2. Administration of financial guarantees demanded by the participants. The settlement guarantee fund is maintained and managed by NCDEX.
9. Physical settlement (by delivery) or financial settlement (by price difference) of contracts.Chapter 9 Clearing and settlement
Most futures contracts do not lead to the actual physical delivery of the underlying asset. On the NCDEX. It guarantees the performance of the parties to each transaction. 4. National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX. Effecting timely settlement.1
Clearing of trades that take place on an exchange happens through the exchange clearing house. The clearing house has a number of members. physical delivery or cash settlement. 5. Trade registration and follow up. in the case of clearing house members only the original margin is required (and
. Control of the evolution of open interest. The settlement is done by closing out open positions. 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). 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.
6. All these settlement functions are taken care of by an entity called clearing house or clearing corporation. Financial clearing of the payment flow.
but can withdraw funds from this account only in his self-name.2 Clearing banks
NCDEX has designated clearing banks through whom funds to be paid and/ or to be received must be settled. the matching for deliveries takes place firstly. 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. at the member level without any set-offs between clients. 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. The cash settlement is only for the incremental gain/ loss as determined on the basis of final settlement price. Thus depending on a day's transactions and price movement. for settling funds and other obligations to NCDEX including payments of margins and penal charges. on the basis of locations and men randomly.. commodities already deposited and dematerialized and offered for delivery etc.118
Clearing and settlement
not maintenance margin). after the trading hours on the expiry date. At NCDEX.e. Every clearing member is required to maintain and operate a clearing account with any one of the designated clearing bank branches. reporting of balances and other operations as may be required by NCDEX from time to time. The clearing account is to be used exclusively for clearing operations i. Proprietary positions are netted at member level without any set-offs between client and proprietary positions.1. keeping in view the factors such as available capacity of the vault/ warehouse. in the contracts in which they have traded.1. The open positions of PCMs are arrived at by aggregating the open positions of all the TCMs clearing through him. based on the available information. 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. in contracts in which they have traded.1 Clearing mechanism
Only clearing members including professional clearing members (PCMs) are entitled to clear and settle contracts through the clearing house. Everyday the account balance for each contract must be maintained at an amount equal to the original margin times the number of contracts outstanding. Unmatched positions have to be settled in cash. The clearing bank will debit/ credit the clearing account of clearing members as per instructions received from NCDEX. Clearing members must authorise their clearing bank to access their clearing account for debiting and crediting their accounts as per the instructions of NCDEX. A TCM's open position is arrived at by the summation of his clients' open positions.
9. After completion of the matching process. This position is considered for exposure and daily margin purposes. The following banks have been designated
. Client positions are netted at the level of individual client and grossed across all clients. A clearing member can deposit funds into this account. The clearing mechanism essentially involves working out open positions and obligations of clearing members. clearing members are informed of the deliverable/ receivable positions and the unmatched positions.
The possibility of physical settlement makes the process a little more complicated.1
Settlement of commodity futures contracts is a little different from settlement of financial futures which are mostly cash settled. when the member holds an open position. daily settlement price is computed as per the methods prescribed by the exchange from time to time.
Daily mark to market settlement
Daily mark to market settlement is done till the date of the contract expiry.2. in the absence of trading for a contract during closing session.
• 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. created during the day or closed out during the day. are marked to market at the daily settlement price or the final settlement price at the close of trading hours on a day. either brought forward. 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. for effecting and receiving deliveries from NCDEX. the MTM settlement which happens on a continuous basis at the end of each day. and the final settlement which happens on the last trading day of the futures contract.
• Final settlement price: Final settlement price is the closing price of the underlying commodity on the
last trading day of the futures contract. This is done to take care of daily price fluctuations for all trades.e. All open positions in a futures contract cease to exist after its expiration day.
• On any intervening days.
9. Canara Bank. The CM pool account is to be used exclusively for clearing operations i. However. 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.2 Settlement
as clearing banks .9.1. UTI Bank Limited and HDFC Bank Limited.. it is the difference between the
daily settlement price for that day and the previous day's settlement price.ICICI Bank Limited. On the NCDEX. All positions of a CM.
Futures contracts have two types of settlements.3 Depository participants
Every clearing member is required to maintain and operate a CM pool account with any one of the empanelled depository participants.
7 Quintals = 11 bales) on December 15.120 per Quintal. The MTM profit/ loss shows that he makes a total profit of Rs. A professional clearing member is responsible for settling all the participants trades which he has confirmed to the exchange. The member closes the position on December 19. he makes a total loss of Rs. i. The profit/ loss made by him however gets added/ deducted from his initial margin on a daily basis.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. The polled bid/ ask prices are bootstrapped and the mid of the two bootstrapped prices is taken as the final settlement price.2244 on the short position taken by him.7 Quintals) and each contract is for delivery of 55 bales of cotton. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton.6435 per Quintal (18.e. the final settlement price is the spot price on the expiry day.2003 Dec 17.1 explains the MTM margins to be paid by a member who buys one unit of December expiration long staple cotton contract at Rs. Table 9.6435 per Quintal on December 15.2003
Settlement price 6320 6250 6312 6310 6315
MTM -115 -70 +62 -2 +5
• On the expiry date if the member has an open position. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. The MTM profit/ loss per unit of trading shows at he makes a total loss of Rs. The MTM profits/ losses get added/ deducted from his initial margin on a daily basis. (18.
Date Dec 15.7 x 120) on the long position taken by him.120 Table 9.120 per Quintal of trading.2003 Dec 19. The member closes the position on December 19. The profit/ loss made by him however gets added/ deducted from his initial margin on a daily basis. Table 9. he makes a total profit of Rs.6435 per Quintal on December 15. The unit of trading is 11 bales(18. So upon closing his position.2244.
On the date of expiry. On the expiry date of a futures contract. So upon closing his position.2 explains the MTM margins to be paid by a member who sells December expiration long staple cotton futures contract at Rs. The spot prices are collected from members across the country through polling.2003 Dec 18.2003 Dec 16. 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. The member closes the position on December 19. it is the difference between the final settlement price and the previous day's settlement price.
clearing and settling through such clearing member. The member closes the position on December 19.
. A detailed report containing all matched and unmatched requests is provided to members through the extranet.2003 Dec 19. It can also take additional measures like.
Date Dec 15. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. NCDEX on receipt of such information.9. may be closed out forthwith or any time thereafter by the exchange to the extent possible. invoking bank guarantees or fixed deposit receipts.2003
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. matches the information and arrives at a delivery position for a member for a commodity. Pursuant to regulations relating to submission of delivery information.6435 on December 15. for which no delivery information is submitted with final settlement obligations of the member concerned and settled in cash. imposing penalties.2 MTM on a short position in cotton futures
A clearing member sells one December expiration long staple cotton futures contract at Rs. 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. The MTM profits/ losses get added/ deducted from his initial margin on a daily basis.2003 Dec 16. Non-fulfilment of either the whole or part of the settlement obligations is treated as a violation of the rules. by placing at the exchange. 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. NCDEX also adds all such open positions for a member.2 Settlement Table 9. failure to submit delivery information for open positions attracts penal charges as stipulated by NCDEX from time to time. Further. NCDEX can also initiate such other risk containment measures as it deems appropriate with respect to the open positions of the clearing members. realizing money by disposing off the securities and exercising such other risk containment measures as it deems fit or take further disciplinary action. collecting appropriate deposits.2003 Dec 17. 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.2003 Dec 18. without any notice.
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.
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.
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.
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.
R&T agents also do the job of co-ordinating with DPs and warehouses for billing of charges for services rendered on periodic intervals. They are required to furnish the same to the exchange as and when demanded by the exchange.
9. and the time up to which the commodities are fit for trading subject to environment changes at the warehouses. 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. security deposits) are quite stringent. Assayers perform the following functions:
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. 2. It also follows value-at-risk (VaR) based margining through SPAN.9. the requirements for membership in terms of capital adequacy (net worth. The PCMs and TCMs in turn collect the initial margin from the TCMs and their clients respectively. Therefore. 2. NCDEX charges an upfront initial margin for all the open positions of a member. The compliance certificate so given by the assayer forms the basis of warehouse accreditation by the exchange. Make available grading facilities to the constituents in respect of the specific commodities traded on the exchange at specified warehouse. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital.
4. The difference is settled in cash on a T+l basis. 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. 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.3 Risk management
NCDEX has developed a comprehensive risk containment mechanism for the its commodity futures market.
. The financial soundness of the members is the key to risk management. It specifies the initial margin requirements for each futures contract on a daily basis. 3.
Position violations result in withdrawal of trading facility for all TCMs of a PCM in case of a violation by the PCM. The open positions of the members are marked to market based on contract settlement price for each contract. 3. The salient features of risk containment mechanism are:
1. 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.3 Risk management
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.
at any point of time.
. 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. Initial margin is payable on all open positions of trading cum clearing members. 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. the exchange has defined norms and procedures for margins and limits applicable to members and their clients. The most critical component of risk containment mechanism for futures market on the NCDEX is the margining system and on-line position monitoring. For proprietary positions: These are netted at member level without any set-offs between client and
proprietary positions. A separate settlement guarantee fund for this segment has been created out of the capital of members.4. 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.2 Initial margin
This is the amount of money deposited by both buyers and sellers of futures contracts to ensure performance of trades executed. Initial margin requirements for a member for each contract are as under:
1. The objective of SPAN is to identify overall risk in a portfolio of all futures contracts for each member. For client positions: These are netted at the level of individual client and grossed across all clients.4. The actual position monitoring and margining is carried out on-line through the SPAN (Standard Portfolio Analysis of Risk) system.1 SPAN
SPAN is a registered trademark of the Chicago Mercantile Exchange. Initial margin requirements are based on 99% VaR (Value at Risk) over a one-day time horizon. The margining system for the commodity futures trading on the NCDEX is explained below. used by NCDEX under license obtained from CME.
Clearing and settlement
2. rules and regulations.4.
9.4 Margining at NCDEX
In pursuance of the bye-laws. at the member level without any set-offs between clients. Initial margin includes SPAN margins and such other additional margins that may be specified by the exchange from time to time.
On account of client A.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
Outstanding position Long 2000 Long 500 Short 1000 3500
Table 9. 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
. For the purpose of SPAN margin. various parameters as given below will be specified from time to time:
1. 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.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. he bought 2000 trading units at the beginning of the day and sold 1500 units an hour later. 2. And on account of client B. These may change from time to time as specified by the exchange.3 gives the total outstanding position for which the TCM would be margined.4 Margining at NCDEX
Table 9. On his proprietary account.
3.4. Price scan range: Price scan range will be four standard deviations (4 sigma) as calculated for VaR purpose for the prices of futures contracts. he bought 3000 trading units and sold 1000 trading units within the day. The minimum margin percentages for various commodities are given in Table 9. Table 9.9. he sold 1000 trading units.
25 lakh (referred to as minimum liquid net worth) or such other amount.
9. fixed deposits receipts and approved Government of India securities. However. invoking bank guarantees/ fixed deposit receipts. The near month position is the buy/ sell position on the calendar-spread position that expires first. 2. 4. A calendar spread position is treated as nonspread (naked) positions in the far month contract. 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. The far month position is the buy/ sell position on the calendar-spread position that expires next. realizing money by disposing off the securities and exercising such other risk containment measures as it deems fit.128
Clearing and settlement
exchange. The reduction of the spread position starts five days before the date of expiry of the near month contract.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. collecting appropriate deposits. 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 outstanding positions of such members and/ or constituents clearing and settling through such members. The exchange can take additional measures like imposing penalties. bye-laws and regulations of the exchange and attracts penal charges as stipulated by NCDEX from time to time. can be closed out forthwith or any time thereafter at the discretion of the Exchange. or in collateral security deposits in the form of bank guarantees. by placing counter orders in respect of the outstanding position of members. Such action is final and binding on the members and/ or constituents. 3 trading days prior to expiration of the near month contract. Payment of initial margin: The initial margin is payable upfront by members. 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. The liquid networth maintained by the members at any point in time cannot be less than Rs. Mode of payment of initial margin: Margins can be paid by the members in cash. as may be specified by the exchange from time to time. 1. In addition. (a) Liquid networth: Liquid networth is computed as effective deposits less initial margin payable at any point in time. 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. or at such rate as may be specified by the exchange from time to time. The trader workstation of the member is disabled and trading permitted only on enhancement of exposure limits by deposit of additional capital. The member is not allowed to trade once the exposure limits have been exceeded on the exchange. 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. 3. 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.
.4. to the extent possible. without any notice.
Imposition of additional margins and close out of open positions: As a risk containment measure. 7. 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. In addition. the exchange may require the members to make payment of additional margins as may be decided from time to time. trading in that particular contract will be suspended and normal trading will resume after the cooling period. During the cooling period. at any point of time. 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. 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. 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. clearing and settling through such members. The multiple is as specified in Table 9. (d) Exposure limits for calendar spread positions: In case of calendar spread positions in futures. as the case may be. the outstanding positions of such members and/ or constituents. 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.e. at the discretion of the exchange. must inform the exchange as per the procedure.
. which are or may have been imposed. If the price hits the intra day price limit (at upper side or lower side). a member can have an exposure limit of x times his liquid net worth.10% of the previous day's settlement price prescribed for each commodity.4 Margining at NCDEX
(b) Effective deposits: This includes all deposits made by the members in the form of cash or cash equivalents form the effective deposits.5 or as may be prescribed by the exchange from time. There would be no cooling period if the price hits the intra day limit during the last 30 minutes of trading. 10. cash equivalents mean bank guarantees. The base price when trading resumes after cooling period will be the last traded price before the commencement of cooling period. (c) Method of computation of exposure limits: Exposure limits is specified as a multiple of the liquid net worth. Such requests may be considered by the exchange subject to the bye-laws. contracts are treated as open position of one third of the value of the far month futures contract. can be closed out forthwith or any time thereafter. without any notice. Open interest is the total number of open positions in that futures contract multiplied by its last available traded price or closing price. rules and regulations. For the purpose of computing effective deposits. Intra-day price limit: The maximum price movement during a day can be +/. bye-Laws and regulations of the exchange and attracts penal charges as stipulated by NCDEX. 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. 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. by placing counter orders in respect of their outstanding positions. This is calculated as the higher of a specified percentage of the total open interest in the commodity or a specified value. 8. fixed deposit receipts and Government of Indian securities. This is in addition to the initial margin. 9. to the extent possible. there will be a cooling period of 15 minutes. 6.9. over and above their deposit requirement towards initial margin and/ or other obligations. i. 5.
(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. (b) On any intervening days.6 gives the number of days for physical settlement on various commodities. Table 9. For example. (c) On the expiry date if the member has an open position. as described hereunder or as may be prescribed by the exchange from time to time.4.130
Table 9. it is the difference between the entry value and daily settlement price for that day. the exchange can withdraw any or all of the membership rights of members including the withdrawal of trading
. or any other situation has arisen. Intra-day margin call: The exchange at its discretion can make intra day margin calls as risk containment measure if.
9. it can make an intra-day margin call if the intra day price limit has been reached. There is a mark up on the VaR based delivery margin to cover for default. 11. it is the difference between the final settlement price and the previous day's settlement price.5 Effect of violation
Whenever any of the margin or position limits are violated by members. delivery margins are
calculated as i\ days VaR margins plus additional margins. N days refer to the number of days for completing the physical delivery settlement. it is the difference between the daily settlement value for that day and the previous day's settlement price. The daily settlement price notified by the exchange is binding on all members and their constituents. the market price changes sufficiently. 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.
12. which in the opinion of the exchange could result in an enhanced risk. in its opinion. when the member holds an open position. for example. only for those members whose variation losses or initial margin deficits exceed a threshold value prescribed by the exchange. The number of days are commodity specific. The exchange at its discretion may make selective margin calls.
A: The correct answer is number 4. collecting appropriate deposits. Q: ____ undertakes clearing and settlement of all trades executed on the NCDEX 1. and exercising such other risk containment measures it considers necessary. realizing money by disposing off the securities. the outstanding positions of such member and/ or constituents clearing and settling through such member. 3. 2. Physical delivery. 4.
Q: The settlement of futures contracts cannot be done by 1. These could include imposing penalties. NSE 2. ••
.9. NSCCL A: The correct answer is number 2. invoking bank guarantees/ fixed deposit receipts. This can be done without any notice to the member and/ or constituent. Carrying forward the position. NCDEX •• 3. Cash settlement. without any notice. can be closed out at any time at the discretion of the exchange. In addition.4 Margining at NCDEX
Table 9.6 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
facilities of all members and/ or clearing facility of custodial participants clearing through such trading cum members. Closing out open positions. NSDL 4. The exchange can initiate further risk containment measures with respect to the open positions of the member and/ or constituent.
Control of the evolution of open interest. 3. Effecting timely settlement. 2. 4. A: The correct answer is number 1.
2. Ensuring that the buyer and seller get the best price. ••
Q: The clearing house of an exchange is not responsible for 1. Spot price plus cost-of-carry 4. Base capital. ••
Q: On expiry of a commodity futures contract. 2. 4. Bank guarantees. A: The correct answer is number 4. ••
. Security deposits.132
Clearing and settlement
Q: The settlement guarantee fund for trades done on the NCDEX is maintained and managed by 1. NSDL 4. Financial clearing of the payment flow. NCDEX ••
Q: The clearing house of an exchange is responsible for 1. 4. ••
Q: The exposure limit for each member is linked to the………of the member available with the exchange. NSE 2. None of the above. Spot price of the underlying asset 2. All of the above. the settlement price is the 1. Financial clearing of the payment flow. 3. Control of the evolution of open interest. 1. Liquid net worth. Futures close price A: The correct answer is number 1. Effecting timely settlement. 3. NSCCL A: The correct answer is number 4. 3. 3. A: The correct answer is number 2.
Long 600 units
A: After netting. The unit of trading is 100 gms and each contract is for delivery of one kg of gold.5610 2. So he makes a profit of 30 * 18. •• 10
Q: A trading member took proprietary positions in a March 2004 cotton futures contract.5610.5610 3. He has bought two units. The settlement price at the end of the day was Rs.5000 4. A profit of Rs. What is the outstanding position on which he would be margined? 1. 1500
A: He makes a profit of Rs.6025 per 10 gms. AprofitofRs.30 per Quintal on his futures position. i.e × 200 = Rs. AlossofRs.500. So he makes a profit of 20 Rs. long staple cotton futures contracts at Rs.6050 per Quintal. He bought 3000 trading units at Rs.500 2.7 Quintals. A profit of Rs. 1500 4. AlossofRs.25 per 10 gms on his futures position. One futures contract consists is for 18. The unit of trading is 11 bales and each contract is for delivery of 55 bales. He makes a profit of Rs. • •
Q: A gold merchant bought two units of one-month gold futures contracts at Rs.6015 per Quintal.7 * 10 = Rs.9. A loss of Rs. ••
. The trader's MTM account will show 1. This means he has a long position in 200 gms of gold.500.5000
A: Each unit of trading is 100 gms. The correct answer is number 1. The settlement price at the end of the day was Rs. the trading member has a long open position in 600 trading units. He has bought ten futures contract.6020 per Quintal at the beginning of the day.6000 per Quintal and sold 2400 at Rs. The correct answer is number 1.4 Margining at NCDEX
Q: A cotton trader bought ten one-month. A loss of Rs.500 3.6000 per 10 gms at the beginning of the day. Short 2400 units 3. The trader's MTM account will show 1. Long 3000 units 2. Long 5400 units 4. AprofitofRs. The correct answer is number 4.
. the trading member has a proprietary open position in 600 trading units.6012 per 10 gms and sold 1500 units at Rs. 4500 units 3. On his proprietary account.5990 per Quintal. 3600 units 4. he sold 1000 trading units at Rs. 3000 units 2. 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. i.e. The correct answer is number 2. 3600 units 4.134
Clearing and settlement
Q: A trading member has proprietary and client positions in a March cotton futures contract. What is the outstanding position on which he would be margined? 1. he bought 3000 trading units at Rs. he bought 3000 trading units at Rs. 8400 units 3. The correct answer is number 3. and on account of client B. he bought 2000 trading units at Rs. He would be margined on a net basis at the proprietary level and on a gross basis across clients. On account of client A. and on account of client B. he bought 2000 trading units at Rs.6000 per 10 gms. On account of client A. (3000 + (2000 . he sold 1000 trading units at Rs. What is the outstanding position on which he would be margined? 1. 3000 units 2.e.6020 per 10 gms. 1600 units
A: After netting. •• Q: A trading member has proprietary and client positions in a April 2004 gold futures contract.6000 per Quintal and sold 2400 at Rs.5990 per 10 gms. (600 + 2000 +1000).6015 per Quintal. On his proprietary account.6012 per Quintal.1500) + 1000). i.
which impinge on their working. which deal with forward contracts. Forward Markets Commission provides regulatory oversight in order to ensure financial integrity (i. 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. namely. The need for regulation arises on account of the fact that the benefits of futures markets accrue in competitive conditions.Chapter 10 Regulatory framework
At present. clearing. Regulation is also needed to ensure that the market has appropriate risk management system. thereby affecting interests of society at large. Forward Commission (Regulation) Act and various other legislations.e. forward trading in commodities notified under section 15 of the Act can be conducted only on the exchanges. unscrupulous participants could use these leveraged contracts for manipulating prices. they are subjected to various laws of the land like the Companies Act. This could have undesirable influence on the spot prices. a major default could create a chain reaction. market integrity (i. Food and Public Distribution). All the exchanges. Under the Forward Contracts (Regulation) Act. Contracts Act. settlement and management of the exchange so as to protect and promote the interest of various stakeholders. there are three tiers of regulations of forward/futures trading system in India. government of India. which are granted recognition by the central government (Department of Consumer Affairs. Proper regulation is needed to create competitive conditions. Besides. to prevent systematic risk of default by one major operator or group of operators). are required to obtain certificate of registration from the FMC. It prescribes the following regulatory measures:
Rules governing commodity derivatives exchanges
The trading of commodity derivatives on the NCDEX is regulated by Forward Markets Commission(FMC). Stamp Act. The resultant financial crisis in a futures market could create systematic risk. 1952. Ministry of Consumer Affairs.
10. Regulation is also needed to ensure fairness and transparency in trading..e. In the absence of such a system. In the absence of regulation. Forward Markets Commission(FMC) and commodity exchanges. particularly nonmember users of the market.
Some times limit is also imposed on intra-day net open position. Trading on the exchange is allowed only through
. exchanges are governed by its own rules and bye laws(approved by the FMC). Limit on net open position as on the close of the trading hours. These steps facilitate audit trail and make it difficult for the members to indulge in malpractices like trading ahead of clients. The limit is imposed operator-wise. these have been divided into two main divisions pertaining to trading and clearing. This measure is imposed only on the request of the exchange. The website of the commission also has a provision for the customers to make complaint and send comments and suggestions to the FMC. 2. the price rise or fall is sobered down. Skipping trading in certain derivatives of the contract. the F. etc. telephone number of the officer of the commission who can be contacted for any grievance.
5.2.2 Rules governing intermediaries
In addition to the provisions of the Forward Contracts (Regulation) Act 1952 and rules framed thereunder. which is more customer-friendly. The FMC has also prescribed simultaneous reporting system for the exchanges following open out-cry system. to ascertain the situation on the ground. closing the market for a specified period and
even closing out the contract: These extreme measures are taken only in emergency situations. clearing and settlement. This measure is also imposed on the request of the exchanges. whenever they visit exchanges. rules and regulations are available on the NCDEX home page. instead of merely attending meetings of the board of directors and holding discussions with the office-bearers. 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. except when a written consent is taken within three days time.
Besides these regulatory measures. address. By making further purchases/sales relatively costly. For the sake of convenience. The FMC is persuading increasing number of exchanges to switch over to electronic trading. In this section we have brief look at the important regulations that govern NCDEX. and in some cases.136
1. the name. The FMC has also mandated all the exchanges following open outcry system to display at a prominent place in exchange premises. 4. 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. Officers of the FMC have been instructed to meet the members and clients on a random basis. also memberwise. The detailed bye laws. 3. Circuit-filters or limit on price fluctuations to allow cooling of market in the event of abrupt upswing or downswing in prices.1
The NCDEX provides an automated trading facility in all the commodities admitted for dealings on the spot market and derivative market.C(R) Act provides that a client's position cannot be appropriated by the member of the exchange.
. installation and maintenance of the equipment is borne by the trading member. The exchange has the right to inspect equipment and software used for the purposes of accessing the trading system at any time. In case of trading members. such certification program has to be passed by at least one of their directors/ employees/ partners / members of governing body. trading members are provided a facility to place orders off-line i. An approved user can access the trading system through a password and can change the password from time to time. Approved user shall be required to change his password at the end of the password expiry period. Other than the regular trading hours. The trading member or its approved users are required to maintain complete secrecy of its password. The appointment of approved users is subject to the terms and conditions prescribed by the exchange. as may be specified by the relevant authority) from time to time • Authorised persons • Approved users
Trading members have to pass a certification program. outside trading hours. will be binding on such trading member. For the purpose of accessing the trading system. He does not have any title rights or interest whatsoever with respect to trading system. Each approved user is given a unique identification number through which he will have access to the trading system. Each trading member is permitted to appoint a certain number of approved users as notified from time to time by the exchange.e.
Trading members and users
Trading members are entitled to appoint. other than individuals or sole proprietorships.2 Rules governing intermediaries
approved workstation(s) located at locations for the offlce(s) of a trading member as approved by the exchange. 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. software and the information provided by the trading system. 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.
The exchange operates on all days except Saturday and Sunday and on holidays that it declares from time to time. the member will install and use equipment and software as specified by the exchange at his own cost. (subject to such terms and conditions. The cost of the equipment and software supplied by the exchange. 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. These are stored by the system but get traded only once the market opens for trading on the following working day. which has been prescribed by the exchange.10. Any trade or transaction done by use of password of any approved user of the trading member. its facilities.
The contract expiration period will not exceed twelve months or as the exchange may specify from time to time.
Failure of trading member terminal
In the event of failure of trading members workstation and/ or the loss of access to the trading system. during which it will be available for trading. The exchange specifies the minimum disclosed quantity for orders that will be allowed for each commodity/ derivatives contract.
Derivatives contracts expire on a pre-determined date and time up to which the contract is available for trading. Every trading member is required to specify the buy or sell orders as either an open order or a close order for derivatives contracts. 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.
Trading hours and trading cycle
The exchange announces the normal trading hours/ open period in advance from time to time.
The exchange from time to time specifies various trading parameters relating to the trading system. within the regulations prescribed by the exchange as per these bye laws. Only requests made in writing in a clear and precise manner by the trading member would be considered. price limits. rules and regulations. price steps in which orders shall be entered on the trading system. the exchange can extend or reduce the trading hours by notifying the members. position limits in respect of each commodity etc. 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. from time to time. 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.138
The types of order books. Trading cycle for each commodity/ derivative contract has a standard period. In case necessary. Members can place orders on the trading system during these sessions. trade books. It also prescribes the number of days after which Good Till Cancelled orders will be cancelled by the system. This is notified by the exchange in advance.
. It specifies parameters like lot size in which orders can be placed. 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.
in respect of the trades in which he is party to. the clearing house releases all margins. on the basis of VaR from the expiry of the contract till the actual settlement date plus a mark-up for default. in which trade cancellation can be effected. On failure to deposit margin/s as required under this clause. sell. as well as the method of valuation and amount of securities that would be required to be deposited against the margin amount. 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. This includes the following: • Effect. 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. which are likely to have effect of
artificially.2 Rules governing intermediaries
Trading members have to ensure tiiat appropriate confirmed order instructions are obtained from the constituents before placement of an order on the system. The procedure for refund/ adjustment of margins is also specified by the exchange from time to time. the exchange/clearing house can withdraw the trading facility of the trading member. the settlement periods and trade types for which margin would be attracted. The exchange can impose upon any particular trading member or category of trading member any special or other margin requirement. 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. Trades generated on the system are irrevocable and 'locked in'. deal in derivatives contracts in a fraudulent manner. The margin is charged so as to cover oneday loss that can be encountered on the position on 99% of the days. Where a trade cancellation is permitted and trading member wishes to cancel a trade. The exchange specifies from time to time the market types and the manner if any. After the pay-out. The exchange prescribes from time to time the commodities/ derivative contracts. every clearing member. or indulge in any unfair trade practices including market manipulation. 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.
Unfair trading practices
No trading member should buy. The exchange also prescribes categories of securities that would be eligible for a margin deposit.10. take part either directly or indirectly in transactions.
Subject to the provisions as contained in the exchange bye-laws and such other regulations as may be in force. it can be done only with the approval of the exchange. The margin has to be deposited with the exchange within the time notified by the exchange. Additional margins may be levied for deliverable positions. raising or depressing the prices of spot/ derivatives contracts.
. has to deposit a margin with exchange authorities.
the last trading day is taken to be the previous working day of exchange.140
• Indulge in any act. accounts and records for the purpose of market manipulation. in cash together with penalty as stipulated by the exchange. bye laws and rules of the exchange. on the basis of locations and then randomly keeping in view the factors such as available capacity of the vault/ warehouse. • When acting as an agent. National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX. which is calculated to create a false or misleading appearance of trading. On the expiry date.
10. On the expiry date of contracts.
Last day of trading
Last trading day for a derivative contract in any commodity is the date as specified in the respective commodity contract. After the trading hours on the expiry date. the trading members/ clearing members have to give delivery information as prescribed by the exchange from time to time. 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. resulting in reflection of prices.firstly. based on the available information. • Buy. • Indulge in falsification of his books.2 Clearing
As mentioned earlier. Matching done is binding on the clearing members. If the last trading day as specified in the respective commodity contract is a holiday. the exchange provides a window on the trading system to submit delivery information for all open positions. execute a transaction with a constituent at a price other than the price at which it was executed on the exchange. • Delay the transfer of commodities in the name of the transferee. the deals have to be settled as per the settlement calendar applicable for such deals. 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.
Delivery can be done either through the clearing house or outside the clearing house.
• 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
.2. the matching for deliveries takes place . If a trading member/ clearing member fails to submit such information during the trading hours on the expiry date for the 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. during the trading hours. which are not genuine.
taxes. All matched and unmatched positions are settled in accordance with the applicable settlement calendar. In no event is the exchange/ clearing house liable for payment of sales tax/ VAT or any other local tax. All members have to ensure that their respective constituents.
. the sales tax and other taxes levied under the local state sales tax law to the extent permitted by law. then the open position would be settled in cash together with penalty as may be stipulated by the exchange. however the seller is entitled to recover from the buyer.
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. whereby the clearing house can reduce the margin requirement to that extent. 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. the exchange closes out the derivatives contracts and imposes penalties on the defaulting buyer or seller. If the information provided by the buyer/ seller clearing members fails to match. 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. sales tax. Unmatched positions have to be settled in cash. who intend to take or give delivery of commodity. The cash settlement is only for the incremental gain/ loss as determined on the basis of the final settlement price. Pay in/ Pay out for such additional obligations is settled on the supplemental settlement date as specified in the settlement calendar. The exchange however. The clearing members are allowed to deliver their obligations before the pay in date as per applicable settlement calendar. 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. fees. They have to mention their preferred identified counter-party and the deliverable quantity. as the case may be.2 Rules governing intermediaries
matching process. is not be responsible or liable for such settlements or any consequence of such alternate mode of settlements. government levies/ fees if any. levies etc. along with other details required by the exchange. from time to time for the quality/ quantity differential. 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. The exchange specifies the parameters and methodology for premium/ discount. The seller is responsible for payment of sales tax/VAT. as the case may be. clearing members are informed of the deliverable / receivable positions and the unmatched positions.10. It can also use the margins deposited by such clearing member to recover the loss.
Penalties for defaults
In the event of a default by the seller or the buyer in delivery of commodities or payment of the price.
are moved out of the electronic deliverable quantity. confirms the deposit of such commodity to the depository for giving credit to the demat account of the said constituent. 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. which have reached the trading validity date. The vault accepts the precious metal. 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).
Process of rematerialisation
Re-materialization refers to issue of physical delivery against the credit in the demat account of the constituent. commodities. Such commodities are suspended from delivery. The constituent has to rematerialize such quantity and remove the same from the warehouse. to the depositor against the deposit of commodity. the commodity must be accompanied with the assayers' certificate.142 Process of dematerialization
Dematerialization refers to issue of an electronic credit. The clearing member has to ensure that his concerned constituent removes the commodities on or before the expiry of validity date for such commodities. confirms the deposit of such precious metal to the depository for giving credit to the demat account of the said constituent. In case of commodities (other than precious metals) the constituent delivers the commodity to the exchange-approved warehouses. On acceptance. In case of precious metals. The vault/warehouse on receipt of such authorisation releases the commodity to the constituent or constituent's authorised person upon verifying the identity. after verifying the contents of assayers certificate with the precious metal being deposited. instead of a vault/ warehouse receipt. the delivery of the commodity upon expiry of validity date is not considered as a good delivery. Failure to remove deliveries after the validity date from warehouse is levied with penalty as specified by the relevant authority from time to time. If the quality of the commodity is as per the norms defined and notified by the exchange from time to time. The exchange provides the list of approved DPs from time to time. For the depository. the vault issues an acknowledgement to the constituent and sends confirmation in the requisite format to the R & T agent who upon verification.
In case of commodities having validity date assigned to it by the approved assayer. 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.
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 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 settlement obligation statement is deemed to have been confirmed by the said clearing member in respect of every and all obligations enlisted therein. notwithstanding that the commodities are located in the warehouse along with the commodities of other constituents. Settlement obligations statements for TCMs: The exchange generates and provides to each trading clearing member. 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.
Payment through the clearing bank
Payment in respect of all deals for the clearing has to be made through the clearing bank(s).
. 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. The delivery and receipt statement contains details of commodities to be delivered to and received from other clearing members.2 Rules governing intermediaries
Delivery through the depository clearing system
Delivery in respect of all deals for the clearing in commodities happens through the depository clearing system. commodities as specified in the delivery and receipt statements. 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. clearing members effect depository delivery in the depository clearing system as per delivery statement in respect of depository deals. the details of the corresponding buying/ selling constituent and such other details.
2. The delivery and receipt statements are deemed to be confirmed by respective member to deliver and receive on account of his constituent. Settlement obligations statements for PCMs: The exchange/ clearing house generates and provides to
each professional clearing member. Provided however that the deals of sales and purchase executed between different constituents of the same clearing member in the same settlement. The delivery through the depository clearing system into the account of the buyer with the depository participant is deemed to be delivery. Delivery has to be made in terms of the delivery units notified by the exchange.
1. shall be offset by process of netting to arrive at net obligations.
Delivery of commodities
Based on the settlement obligations statements. On respective pay-in day.
Clearing and settlement process
The relevant authority from time to time fixes the various clearing days.10.
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. the civil courts at Mumbai have exclusive jurisdiction and in all other matters. whether or
not there is a claim against such person. we define the following:
• Arbitrator means a sole arbitrator or a panel of arbitrators.3 Rules governing investor grievances. Clearing Members operate the clearing account only for the purpose of settlement of depository deals entered through the exchange. 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.
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. 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. arbitration
In matters where the exchange is a party to the dispute.144
Commodities. • Applicant means the person who makes the application for initiating arbitral proceedings. Electronic delivery is available for trading before expiry of the validity date. Every clearing member must have a clearing account with any of the Depository Participants of specified depositories. for the collection of margins by way of securities for all deals entered into through the exchange. 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. The exchange also specifies from time to time the variations permissible in delivery units as per those stated in contract specifications. for the collection of margins by way of commodities for deals entered into through the exchange. The clearing member cannot operate the clearing account for any other purpose. which are to be received by a clearing member. For the purpose of clarity.
• Respondent means the person against whom the applicant lodges an arbitration application.
The exchange specifies from time to time the delivery units for all commodities admitted to dealings on the exchange.
difference or dispute are to be referred to a panel of three arbitrators. However. the exchange returns the deficient/ defective application to the applicant. the applicant has the right to file a revised application. difference or dispute is more than Rs. The date of expiry of 5 days from the date of lodgment of dematerialized request by the constituent for
transfer with the seller. invoice and delivery challan. difference or dispute. Copies of member . The respondent(s) should within 15 days from the date of receipt
10. the date of dispute is deemed to have arisen on
1. then such claim. in such claim. Upon receipt of Form No. the exchange forwards a copy of the statement of case and related documents to the respondent. If the value of the claim.
2. The Applicant has to also submit to the exchange the following along with the arbitration form:
1. then they are to be referred to a sole arbitrator.constituent agreement. then the arbitrator is appointed in the manner as specified in the regulation. whichever is later. Form No. Where any claim. The date of receipt of communication of warehouse refusing to transfer the commodities in favour of the constituent.3. A cheque/ pay order/ demand draft for the deposit payable at the seat of arbitration in favour of National Commodity & Derivatives Exchange Limited. 3.1
Procedure for arbitration
The applicant has to submit to the exchange application for arbitration in the specified form (Form No. The statement of accounts. I/IA) along with the following enclosures:
1. to whom such agent of the member is affiliated. The respondent then has to submit Form H/HA to the exchange within 7 days from the date of receipt. difference or dispute is up to Rs. If the applicant fails to rectify the deficiency/ defect within the prescribed period. 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. The statement of case (containing all the relevant facts about the dispute and relief sought).3 Rules governing investor grievances. arbitration
If the value of claim.I/IA.10. If any deficiency/ defect in the application is found. If the respondent fails to submit Form n/HA within the time period prescribed by the exchange. Copies of the relevant contract notes. II/IIA containing list of names of the persons eligible to act as arbitrators. In case the warehouse refuses or fails to communicate to the constituent the transfer of commodities.25 Lakh. 2.25 Lakh on the date of application. difference or dispute arises between agent of the member and client of the agent of the member. the member.
2. which will be considered as a fresh application for all purposes and dealt with accordingly. is impeded as a party.
UMIIA from the respondent the exchange forwards one copy to the applicant.146
of Form No. 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. by their mutual consent. the arbitrator offers to hear the parties to the dispute unless both parties waive their right for such hearing in writing. In such a case the arbitrator proceeds to decide the matter on the basis of documents submitted by both the parties provided. are awarded to either of the party in addition to the fees and charges. The applicant should within ten days from the date of receipt of copy of Form III/TIIA. a reply to any counterclaim. submit to the exchange in Form No.ni/IIIA If the respondent fails to submit Form III/niA within the prescribed time. the parties settle the dispute. unless the parties. the time and place of the first hearing. which may have been raised by the respondent in its reply to the applicant. The costs. If after the appointment of an arbitrator. the time and place of subsequent hearings of which the exchange gives a notice to the parties concerned.3.25. submit to the exchange. then the arbitrator can proceed with the arbitral proceedings and make the award ex-parte.
10.000 or less. waive the notice. if any.
. I/IA from the exchange.000. If the value of claim. difference or dispute is more than Rs. • Copies of the relevant contract notes. Upon receiving Form No. However the arbitrator for reasons to be recorded in writing may hear both the parties to the dispute. The exchange in consultation with the arbitrator determines the date. then the arbitrator records the settlement in the form of an arbitral award on agreed terms. The arbitrator determines the date.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.25. 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. 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. as decided by the arbitrator. if any. Notice for the first hearing is given at least ten days in advance. 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. The exchange then forwards the reply to the respondent.
3. Open order or close order 2. Mumbai A: The correct answer is number 2. the FMC prescribes certain regulatory measures. Government of India 2. call order or put order A: The correct answer is number 1. Government of India 2. Price determination •• 3. 4. Q: To ensure financial integrity and market integrity. bid order or ask order ••
Q: In matters where the NCDEX is a party to the dispute. which deal with forward contracts. the civil courts at ______ have exclusive jurisdiction. Commodity board of trading •• 3. 3.10. Forward Markets Commission(FMC) A: The correct answer is number 2. Special margin deposits. 1. Forward Markets Commission(FMC) A: The correct answer is number 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. Commodity exchanges 4. Circuit-filters or limit on price fluctuations. 2. arbitration
Q: Which of the following is not involved in regulating forward/futures trading system in India? 1. 3. Commodity exchanges 4. Ahmedabad 4. are required to obtain certificate of registration from the 1.3 Rules governing investor grievances. 1. Which of the following is not a measure prescribed? 1. Q: All the exchanges. take order or give order 4. Limit on net open positions. Calcutta ••
. A: The correct answer is number 4. Delhi 2.
000 2.10. the exchange in consultation with the _ determines the date. 1.00. 1.25. Rs. Respondent 2.148
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. 1.50. the time and place of the first hearing.000 A: The correct answer is number 1.000 4. Q: In the case of an arbitration. Rs. Rs. Warehouse •• 3. Rs.000 ••
.25.000 or less. Applicant A: The correct answer is number 3. 3. Arbitrator 4.
. • It is the responsibility of the selling constituent to comply with the relevant local state sales tax laws and other local enactments. 2. The fact that delivery could happen across various states. etc. sales tax at the rates applicable in the state where the delivery center is located will be payable. • When the futures contract fructifies into a sale and culminates into delivery. also provide for levy of additional tax. filing of returns. Obtaining registration under the relevant state sales tax laws. 3. there is no liability for payment of sales tax. Complying with any check-post regulations prescribed under the local sales tax. turnover tax. makes the issue a little complicated. octroi. there would be liability for payment of sales tax. entry tax or other municipal laws and ensuring that the prescribed documents accompany the goods. • 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. • If the futures contract is closed out and settled between the constituents prior to the settlement date without actually buying or selling the commodities. 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. payment of taxes and due compliance of laws. The selling constituent will be responsible for the following: 1. In many states. Liability for central sales tax if the commodities are moved from outside the state pursuant to a transaction of sale. the sales tax laws.. The present understanding of the implications are given below for reference. when the commodities are brought into the designated local area for lodging the same with the warehouse. Payment of entry tax. 4. etc. 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. In the case of settlements culminating into delivery. resale tax. 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. which may or may not be recoverable from the buyer depending on the provisions of the local state sales tax law.
• It is the responsibility of the buying constituent to comply with the applicable local state sales tax laws and other local enactments. Warehouse 2. entry tax or other municipal laws to enable the seller to avail of exemption or deduction as provided in the relevant laws. 6. the payment of sales tax is to be done in the state in which the _ is situated. filing of returns. 1.150
Implications of sales tax
Q: When the futures contract fructifies into a sale and culminates into delivery. 1. payment of taxes and due compliance of laws. 3. The buying constituent will be responsible for the following: 1. Sale A: The correct answer is number 3. Furnishing of duly completed declaration forms and certificates prescribed under the local sales tax. 3. Delivery 4. Furnishing of duly completed sales invoices. Clearing corporation 2. Exchange •• 3. Warehouse A: The correct answer is number 2. Obtaining registration under the relevant state sales tax laws based on the purchase of commodities. Buyer and seller ••
. entry tax or other municipal laws to enable the buyer to avail of exemption or deduction as provided in the relevant laws. Buyer A: The correct answer is number 4. Seller ••
Q: It is the responsibility of the __ to comply with the relevant local state sales tax laws and other local enactments. Seller 4. The selling constituent may move the commodities into the warehouse well in advance and ensure compliance of provisions of law. 1. Q: The issue of paying sales tax arises only when the futures contracts fructifies into a sale and culminates into____ of the underlying. declaration forms and certificates prescribed under the local sales tax. Payment 2. Buyer 4.
• Futures. • Derivatives FAQ by Ajay Shah and Susan Thomas • Escape to the futures by Leo Melamed • Futures and options by Hans R.gov. • Rubinstein on derivatives by Mark Rubinstein.Stoll and Robert E. • Options.151
The readings suggested here are supplementary in nature and would prove to be helpful for those interested in learning more about derivatives. options and swaps by Robert W. Whaley • Futures and options in risk management by Terry J. Watsham. Dubofsky.in
.com • http://fmc. futures and other derivatives by John Hull. • http://www. • Introduction to futures and options markets by John Kolb • Options and financial future: Valuation and uses by David A. • Derivative markets in India 2003 edited by Susan Thomas.ncdex. Kolb.
14 swaptions. 60 maintenance. 60 swaps. 17 short call. 62 writer. 61 in-the-money. 106 trigger. 61 put. 104 GTC. 14 commodity. 14
. 66 put. 76 delivery. 61 premium. 60 option american. 57 futures. 12 spot. 18 basis. 19 derivatives exchange traded. 106 settlement physical. 60 baskets. 105 GTD. 61 call. 60 MTM. 61 index. 12 warrants. 61 european. 14 transaction forward. 13 forwards. 61 at-the-money. 61 intrinsic value. 61 order day. 14 currency. 105 IOC. 105 price limit. 105 stop-loss. 60 cost-of-carry. 68 margin initial. 10 assignment. 13 OTC. 62 out-of-money. 86 hedgers. 14 cost of carry. 10 spot price. 14 interest rate.Index
arbitragers. 87 short. 69 speculators. 10 long call. 77 hedge long. 61 stock. 61 time value. 61 buyer. 67 put.