Derivatives and

commodity Market
Prepared by: Sudarshan Sharma
What Is a Derivative?
It has no independent value.
Its value is entirely derived from the value of an
underlying asset.
The underlying asset can be securities, commodities,
bullions and currencies, Livestock or anything else.
Derivative is a contract between two or more parties whose
value is based on an agreed-upon underlying financial asset
(like a security) or set of assets (like an index). Common
underlying instruments include bonds, commodities,
currencies, interest rates, market indexes, and stocks. 

Generally belonging to the realm of advanced investing,

derivatives are secondary securities whose value is solely based
(derived) on the value of the primary security that they are
linked to. In and of itself a derivative is worthless. Futures
contracts, forward contracts, options, swaps, and warrants are
commonly used derivatives.
A futures contract, for example, is a derivative because
its value is affected by the performance of the underlying
asset. Similarly, a stock option is a derivative because its
value is "derived" from that of the underlying stock.
While a derivative's value is based on an asset, ownership
of a derivative doesn't mean ownership of the asset.
There are two classes of derivative products - "lock" and
"option". Lock products (e.g. swaps, futures, or
forwards) bind the respective parties from the outset to
the agreed-upon terms over the life of the contract.
Option products (e.g. interest rate swaps), on the other
hand, offer the buyer the right, but not the obligation, to
become a party to the contract under the initially agreed
upon terms.
The risk-reward equation is often thought to be the
basis for investment philosophy and derivatives can be
used to either mitigate risk (hedging) or assume risk
with the expectation of commensurate reward
(speculation).
For example, a trader may attempt to profit from an
anticipated drop in an index's price by selling (or going
"short") the related futures contract. Derivatives used
as a hedge allow the risks associated with the
underlying asset's price to be transferred between the
parties involved in the contract.
A derivative is a contract between two or more parties
whose value is based on an agreed-upon underlying
financial asset, index or security.
Futures contracts, forward contracts, options, swaps,
and warrants are commonly used derivatives.
Derivatives can be used to either mitigate risk
(hedging) or assume risk with the expectation of
commensurate reward (speculation).
Commodity Market
Commodity Market
A commodity market is a physical or virtual marketplace
for buying, selling, and trading raw or primary products.
There are currently about 50 major commodity markets
worldwide that facilitate trade in approximately 100
primary commodities.
Commodities are split into two types: hard and soft
commodities. Hard commodities are typically natural
resources that must be mined or extracted—such as gold,
rubber, and oil, whereas soft commodities are
agricultural products or livestock—such as corn, wheat,
coffee, sugar, soybeans, and pork.
Commodity Market
Investors can gain exposure to commodities by
investing in companies that have exposure to
commodities or investing in commodities directly via
futures contracts. 
The major U.S. commodity exchanges are the Chicago
Board of Trade, the Chicago Mercantile Exchange, the
New York Board of Trade, and the New York
Mercantile Exchange.
How Commodity Markets Work
Commodities can be invested in numerous ways. An
investor can purchase stock in corporations whose
business relies on commodities prices or purchase
mutual funds, index funds, or exchange-traded funds
(ETFs) that have a focus on commodities-related
companies.
The most direct way of investing in commodities is by
buying into a futures contract. A futures contract
obligates the holder to buy or sell a commodity at a
predetermined price on a delivery date in the future.
Types of Commodity Markets
The major exchanges in the U.S., which trade commodities,
are domiciled in Chicago and New York with several
exchanges in other locations within the country. The
Chicago Board of Trade (CBOT) was established in
Chicago in 1848. Commodities traded on the CBOT include
corn, gold, silver, soybeans, wheat, oats, rice, and ethanol.
The Chicago Mercantile Exchange (CME) trades
commodities such as milk, butter, feeder cattle, cattle, pork
bellies, lumber, and lean hogs.
The Commodity Futures Trading Commission (CFTC) is
the main regulatory body for commodity markets in the
U.S. 
The New York Board of Trade (NYBOT) commodities
include coffee, cocoa, orange juice, sugar, and ethanol trading
on its exchange. The New York Mercantile Exchange
(NYMEX) trades commodities on its exchange such as oil,
gold, silver, copper, aluminum, palladium, platinum, heating
oil, propane, and electricity.
Key commodity markets in regional centers include the
Kansas City Board of Trade (KCBT) and the Minneapolis
Grain Exchange (MGE). These exchanges are primarily
focused on agriculture commodities. The London Metal
Exchange and Tokyo Commodity Exchange are prominent
international commodity exchanges.
Commodities are predominantly traded electronically;
however, several U.S. exchanges still use the open outcry
method. Commodity trading conducted outside the
operation of the exchanges is referred to as the over-the-
counter (OTC) market.
In Nepal
Name Abbreviat Locatio Product Types
ion n
Commodities & Metal
Exchange Nepal Ltd. COMEN Nepal Gold, Silver
Kathma
Nepal Derivative Agricultural, Precious Metals,
Exchange Limited [NDEX] ndu, Base Metals, Energy
Nepal
Derivative and Kathma Agricultural, Bullion, Base
Commodity Exchange DCX ndu,
Metals, Energy
Nepal Ltd. Nepal
Kathma
MEX Nepal MEX ndu, Agricultural, Bullion, Base
Metals, Energy
Nepal
Nepal Spot Exchange Kathma
NSE ndu, Agricultural, Bullion
Limited
Nepal
Commodity Trade
Commodity trade is the overall process of trading
products without qualitative differentiation, meaning
products are considered the same regardless of the
producer. In most cases these products are raw
materials which are used in many production
processes. To get an idea of the different type of
commodities view our industries pages. Commodity
trade takes place on regulated exchanges all over the
world. On an exchange, futures contracts are traded.
These are standardized contracts which record the
quality and quantity of a commodity that is being
traded as well as the price and delivery date.
Actors
There are a number of actors active on the commodity
market or who depend on this market to buy and sell
their products. These actors are, in different degrees,
affected with the activities that take place on these
markets. They are however not only affected by the
activities but also play a role in generating activity on
the market.
Producers
The producers supply the input for the commodity market.
Without them there wouldn’t be any products to trade.
Producers have two advantages when they sell their products
on the commodity market. They will sell their products
before they are actually realized. This way they minimize the
risk of imbalance of the market. They can match their supply
to meet the demand. Hereby minimizing the risk of over or
under supplying the market. Producers can also cover
themselves against adverse price movements by selling their
products for a pre determined price. This protects them
against lower prices, but also excludes them from possible
higher prices.
Industrial end-users
The industrial end-users do not directly negotiate prices and other
specifics with the producers. This is usually done by commercial
intermediaries. There are a number of reasons for end-users to rely on
intermediaries for their supply of materials instead of governing this
aspect themselves. First of all it can take a lot of time to find the goods
with the required quality on the market, whereas specialized
intermediaries can perform this task much faster. A second advantage is
that intermediaries are able to create the best possible balance between
the end-users need for a zero-inventory and producers need for
production liquidity. Thirdly the commodity market presents an
opportunity to reduce cost risks. By using futures and forwards, the risk
of adverse price movements is reduced. Lastly when end-users agree on
a contract with an intermediary, the market risks are transferred to the
intermediary.
Trading companies
Trading companies or independent traders perform an essential
role on the commodity market. They negotiate an acceptable price
with both producers and buyers. Thus creating a balance between
supply and demand, upon which the market price is based.
Furthermore they not only arrange a price for both parties, but also
manages the physical products. Hereby the trading company
obtains risks concerning the inventory and volatile prices. In many
cases a trading company will maintain an inventory of a
commodity for industrial transformation of a commodity. Due to
the time delay between producers and end-users, trading
companies need to constantly hedge their commodities to protect
from price differences due to the time delay between acquiring the
product and delivering it.
Contracts
The physical commodity market is an over-the-counter (
OTC) market, where two parties agree on a contract to
deliver and buy a commodity. These contracts are in
many cases unique because they are set up in such a
manner that they meet the specific needs of both
parties. A contract is however not written from scratch
for every single transaction. Usually a standard contract
from a leading company is used as a basis for an
individual contract. Thus a contract is relatively
standard, with the exception of certain aspects. A
number of aspects are determined for each contract.
Quantity
First of all the quantity of the commodity must be
determined, to be able to settle the other aspects of a
contract. The quantity can be expressed in a lot of
different measurement units. It can be expressed in a
metric unit, an Anglo-Saxon unit or in a traditional
measurement unit such as a barrel or bag. Contracts
usually have a clause which arranges for a third
independent party to verify the quantity of a delivery.
Quality
Quality is an important aspect of a contract. A number
of requirements will be determined which must be
met by the supplier. Depending on the commodity, the
degree of importance of the quality may vary. When a
contract uses optional qualities, a difference in quality
can be compensated by the use of premiums or
discounts. These aspects must be specified in the
contract.
Price
The price of the commodity is obvious an essential
part of a contract. The other sections of the contract all
generate input for determining the price. A price can
be settled in many different ways, ranging from a fixed
price to a market related price.
Delivery
The delivery of a commodity is an essential part of a contract, because
delivery can form a significant expenditure. Therefore it is important
this aspect is covered in the contract, so both parties know which aspect
of delivery will generate costs for them. There are different methods for
determining which party and to which degree is responsible for the
transportation of the commodity. These responsibilities are
standardized in a number of international transport terms, called
Incoterms. By using incoterms, the risk of misunderstandings regarding
transport responsibilities can be almost eliminated.
Apart from the shipping method and responsibilities, the delivery
location will be mentioned in a commodity contract. For many
commodities, there are designated locations upon which the exchange
of the physical commodities takes place. These standardized locations
will be used in many of the commodity contracts. There is however also
the possibility of agreeing on a different location upon which the
delivery will take place. This will depend on the negotiations between
two parties.
Managing Commodity Trade
Commodity trade is a highly complex process involving
different aspects which all need to be managed
properly in order to meet international requirements
and more importantly increase profits. Agiblocks offers
an innovative and easy-to-use solution for managing all
aspects of commodity trade, from contracts to
invoicing, creating deliveries and managing risks. The
flexibility and endless possibilities of Agiblocks provide
you with an unique chance to take full advantage of the
opportunities presented by the commodity markets
The objective of the commodity exchange is to provide an effective and
competitive marketplace for trading. It enforces rules and regulations for
the trading of commodities and the contracts. It is a physical centre
where the trading actually takes place. The contracts at the exchange are
standardized. There is no difference between the commodity coming
from one producer and the same commodity coming from the another
producer. The commodity is the same regardless of the producer. All the
commodities of the same type have the same price. The commodities
traded at the exchange have to meet a minimum quality standard. The
exchange settles futures contract, offers settlement guarantee fund and
follows risk management practices. Thus commodity exchange is
important for trading and these are the benefits of commodity exchange.
The commodity market works on the economic principle of supply and
demand. If the supply is less than the demand then the prices of the
commodities go up. When there is a surplus of any commodity the
producer will reduce the price to clear the market. The reduced prices
will drive up the sales.
Benefits of a commodities exchange
A commodity exchange may act in a broader range of
ways, in order to stimulate trade in the commodity sector.
This may be through the use of instruments other than
futures, such as the cash or “spot” trade for immediate
delivery, forward contracts on the basis of warehouse
receipts, or the trade of farmers’ repurchase agreements
for financing known as “repos”.
Alternatively, it may be through focusing on facilitative
activities, rather than on the trade itself, as is the case in
Turkey, where exchanges have served as centres for
registering transactions for tax purposes.
Benefits of a commodities exchange
By trading on a commodity exchange the benefits are numerous.
There is an efficient price discovery mechanism since a commodity
exchange is ideally bringing in large number of buyers and sellers.
Because of the laid-down rules and procedures which ensures a
guaranteed settlement system it reduces price risks.
Deals are transparent in that prices are published and market
information is available to all players.
Availability of rules of transacting across the exchange ensures the
integrity of member companies and brokers is monitored.
The exchange system makes available a dispute settlement system
through rules of arbitration, which offers a shorter route to the
court system.
Benefits of a commodities exchange
The exchange ensures maintenance of standards of quality of
commodities and trading practices.
It also offers cost effective marketing system through
transparent transaction costing and pricing of the
commodities.
 Commodity exchange contracts are signed by both parties and
are legally binding hence there is security, certainty and
transparency.
The contracts will cover, quality, quantity, passing of ownership
and risk, price, payment terms, inspection, transport, delivery
and weight, packaging, force majeure, demurrage, interest and
arbitration.
Benefits of a commodities exchange
The futures trading allow producers and buyers to offset the effects
of adverse future price movements through transparent,
standardised, and efficient hedging of agricultural commodity
prices.
One of the primary functions of a commodity exchange is price
discovery.
Price discovery refers to the mechanism through which prices come
to reflect known information about the market.
The price level established on the open market can therefore
represent an accurate depiction of the prevailing supply/demand
situation in the underlying commodity markets, whether in the spot
market for current deliveries or in the forwards/futures markets for
deliveries at specified time and place.
Benefits of a commodities exchange
Farmers are more likely to find a market for crops when true level
of demand is reflected in the price signals.
Farmers become more informed about market and pricing
information. There is improved received price from intermediaries
because of authoritative and accurate reference price.
Cropping based on futures rather than spot price increases likely
returns and facilitates crop diversification where farmers can
better appreciate price, and ultimately income differentials.
It reduces intra-seasonal spot price volatility, increases returns to
farmers as better enables them to hold until price level is good and
empowers farmers as they can take more marketing decisions into
their own hands.
Benefits of a commodities exchange
The futures also take a price risk management function as it helps
farmers to avoid serious losses when prices fall.
It enables farmers to receive a guaranteed price from a purchaser or
intermediary and facilitates more effective planning and
investment because of greater income predictability
Despite the above obvious advantages there are barriers that will
hinder smallholder farmers from participating in a commodity
exchange.
These include contract sizes that may far exceed the annual
quantity of production those smallholder farmers are capable of;
lack of knowledge, resources and capacity; infrastructure
deficiencies; and cumbersome process of execution that may be
beyond the farmer’s capacity.
Benefits of a commodities exchange
Farmers may be able to break these barriers by participating through
commodity associations or farmers’ associations who aggregate the hedging
needs of several small-scale farmers and execute the trade on the exchange.
 The association or farmers’ union can manage the positions in the market
and liquidate the contract at an appropriate time.
The use of warehouse receipts system allows for farmers as individuals or
groups to deposit their produce in registered warehouses thereby reducing
post harvest storage losses and solving lack of storage challenges.
Warehouse receipts can be negotiable or transferable and used as collateral by
smallholder farmers thereby improved access to finance.
Farmers are well informed of movements in the markets and are able to access
markets rapidly, so they can wait to sell at the right time for the best price.
 Market information and knowledge improves bargaining position for the
farmers, create production incentives, and stimulate competition among the
traders and matches supply and demand.
Benefits of a commodities exchange
Warehouse receipts can be negotiable or transferable
and used as collateral by smallholder farmers thereby
improved access to finance.
Farmers are well informed of movements in the
markets and are able to access markets rapidly, so they
can wait to sell at the right time for the best price.
Market information and knowledge improves
bargaining position for the farmers, create production
incentives, and stimulate competition among the
traders and matches supply and demand.