The Commodity Markets

Introduction

• Indian farmer / agriculture confronted with

issues related to ____
 Commodity

A “commodity” is a raw material or a raw

material that has undergone primary
processing, having commercial value and
which can be produced, bought, sold and
consumed.
 Evolution of Commodity Markets

• Need for ensuring the continuous supply of

seasonal agricultural crops.

• Japan – ‘Rice Tickets’

– Merchants stored rice in warehouses for future
use.
– In order to raise cash, warehouse holders sold
receipts against the stored rice.
 Evolution of Commodity Markets…

• 19th Century,
• Chicago – Wheat
• CBOT – 1848
– Started as ‘spot’ market, but evolved into future
market
• India
– Bombay Cotton Trade Association - 1875 (First
organized Exchange in India )
 Economic Benefits of
Commodity Futures Markets
• Price Discovery
– Buyers and Sellers trade based on
• Inputs regarding specific market information, expert
views and comments, demand and supply equilibrium,
government policies, inflation rates, weather forecasts,
market dynamics
• Price-Risk Management
– Hedging
 Legal Framework

Ministry of Consumer Affairs, Food and Public Distribution

Forward Markets Commission

FC(R) Act 1952
FCRR 1954
Regulations

Commodity Exchanges
Bye-Laws and Business rules
 Market Status

5 National Level Exchanges

16 Regional Exchanges / Associations

Over 90 commodities are given permission

for futures trading
♦ Multi Commodity Exchange of India Ltd., Mumbai
♦ National Commodity & Derivatives Exchange Ltd., Mumbai
♦ National Multi Commodity Exchange of Limited., Ahmedabad
♦ Indian Commodity Exchange Limited, Gurgaon
♦ Ace Derivatives and Commodity Exchange Limited, Ahmedabad
♦ Bikaner Commodity Exchange Ltd.,
♦ Bombay Commodity Exchange Ltd., Vashi
♦ Chamber Of Commerce, Hapur
♦ Central India Commercial Exchange Ltd., Gwalior
♦ Cotton Association of , Mumbai
♦ East India Jute & Hessian Exchange Ltd., Kolkata
♦ First Commodity Exchange of India Ltd.,
♦ Haryana Commodities Ltd., Sirsa
♦ Pepper & Spice Trade Association.,
♦ Meerut Agro Commodities Exchange Co. Ltd.,
♦ National Board of Trade,
♦ Rajkot Commodity Exchange Ltd.,
♦ Rajdhani Oils and Oilseeds Exchange Ltd.,
Surendranagar Cotton oil & Oilseeds Association
♦
Ltd., Surendranagar
♦ Spices and Oilseeds Exchange Ltd. Sangli
♦ Vijay Beopar Chamber Ltd., Muzaffarnagar
 Derivatives Derivatives

• Derivatives are financial contracts, which

derive their value from an underlying asset.
• Asset can be an equity, commodity, foreign
exchange, interest rates, etc
• Broadly 4 types –
• Forwards,
• Futures,
• Options and
• Swaps
 Forward Contract
• Forward contract is an agreement between
two parties
– to Buy or Sell an asset
– at future date for price agreed upon while signing
the contract
• Forward contract is not traded on the
exchange
 Futures Contract
“Futures contract” is an agreement between two parties
to buy or sell an asset of a
specified quantity
specified quality
at a specific time in future
at a specific price
through an organized Exchange
• Long Futures Position – The Party who has agreed to buy
• Short Futures Position – The Party who has agreed to sell
• Futures Price – The price agreed by the two parties
Forward Contracts Vs Futures Contracts

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually one specified delivery date Range of delivery dates

Settled at maturity Settled daily

Generally Physical Delivery Contract usually closed out
prior to maturity
 Options andOptions
Swapsand Swaps
• An ‘Option’ is right but not obligation to the
option owner, to buy or sell an underlying
asset at a specific price at a specific time
period in future.

• A ‘Swap’ is an agreement to exchange cash

flows at specified future times according to
certain specified rules
 Pricing of Futures

F=S+C
F = S (1 + r)^T
r = cost of financing (%) – annually compounded
T = time till expiration of contract

If ‘r’ is compounded ‘m’ times in a year

F = S (1+r/m)^mT
m = no. of times compounded in a year
 Pricing of Futures …

• If compounded continuously / daily

F = S * e^rT
e = 2.71828
Calculate: Fair value of a 4-month futures contract
100 gm of gold in the spot market is Rs. 80,000 and
cost of financing is 12 % p.a., when
a) compounded monthly
b) compounded continuously/daily
Pricing of Commodity Futures
Pricing of Commodity Futures …
Convergence of Spot and Futures Prices

Futures
Price

Spot Price

Time

(a) 2.19
 Participants in Futures Market

1) Hedgers
– Protection from price fluctuation
– Risk averse / mitigation
2) Speculators
– Profit from price fluctuation
– Risk takers
3) Arbitragers
– Risk-less Profit seekers
 Hedging

• Hedging is taking a position in the futures

market that is opposite to a position in the
physical/spot market with objective of
reducing or limiting risks associated with price
changes
• Hedging is the most common method of Price
Risk Management
 Long and Short Hedge
• A long futures hedge is appropriate when you
know you will purchase an asset in the future
and want to lock-in the price

• A short futures hedge is appropriate when

you know you will sell an asset in the future
and want to lock-in the price
 Long Hedge …
• Wheat miller enters in to a contract to sell
wheat flour to a bread manufacturing
company three months from now

– Now – March 2011 –

• Price, Quantity and Quality is agreed
– Future – June 2011 –
• Wheat Miller has to deliver wheat flour to bread
manufacturing company
 Long Hedge …
• Say Currently March 2011,
– Wheat Price Rs. 1000/- per Quintal
• What should Wheat Miller should do to
mitigate risk ?
• Participate in Commodity Futures Market
• How ?
• Buy 3-month (June 2011) Wheat Futures Contract
which gives delivery of Wheat in June 2011
• June 2011 (3-month) Future contract price quoted now is
Rs. 1055 per Quintal
 Long Hedge …

• How Wheat Millers Risk is mitigated ?

• In June 2011,
Price of Wheat in Spot Market / Mandi
– May Increase or Decrease
 Long Hedge Example …
• If spot price in June 2011 is increased to
Rs. 1100 per Quintal

Loss in Spot Market

= Current Spot Market Price - Price if he had purchased
in March 2011
= 1100 - 1055
= 45
Gain in Futures Market
= Current Future Price - Price of Futures contract
purchased / bought in March 2011
= 1100 – 1055
= 45
 Long Hedge Example …
• If spot price in June 2011 is decreased to
Rs. 900 per Quintal

Gain in Spot Market

= Price if he had purchased in March 2011 - Current Spot
Market Price
= 1055 - 900
= 155
Loss in Futures Market
= Price of Futures contract purchased / bought in March
2011 - Current Future Price
= 1055 – 900
= 155
 Short Hedge Example

• Farmer wants protect price for his turmeric

crop which will be harvested in 6-months from
now
• Current Turmeric Price is Rs. 15,000 per Qtl
• Fair Value of 6-month (March 2011) Futures Contract
= Rs. 15,000 + C (1,000) = Rs. 16,000
Participate in Commodity futures, How ?
Sell 6-month Turmeric Futures contract now in
March 2011
 Short Hedge Example…

• Price of Turmeric in September 2011 may increase or

decrease
a) If increased to Rs. 18,000 per Qtl in September 2011
• What farmer has to do ?
• Buy the futures contract at Rs. 18,000 per Qtl
• Loss on Futures Contract = 18,000 – 16,000 = Rs. 2,000
• Sell the Turmeric in Spot Market / Mandi
• Gain in Spot Market = 18,000 – 16,000 (what he expected) =
Rs. 2,000
 Short Hedge Example…
b) If decreased to Rs. 14,000 per Qtl in September 2011
• What farmer has to do ?
• Give delivery of Turmeric against the Turmeric Future
contract he sold
Or
• Buy the futures contract at Rs. 14,000 per Qtl
• Gain on Futures Contract = 16,000 – 14,000 = Rs. 2,000
• Sell the Turmeric in Spot Market / Mandi
• Loss in Spot Market = 16,000 – 14,000 = Rs. 2,000
 Hedge Ratio

• Hedge ratio is the ratio of the number of

futures contracts to be purchased or sold to
the quantity of the cash asset that is required
to be hedged
Hedge Ratio …
 Basis

• Basis = Cash/Spot Price – Future Price

– Negative / Positive

• Strengthening of basis
– Cash price increasing at a faster rate than future
price
– Strong Basis is indicative of short supply in spot
market
 Spread

• Spread is the difference in prices of two

futures contracts

– Intra-commodity spread
– Inter-commodity spread
 Arbitrage

• Arbitrage means locking-in a profit by

simultaneously entering into transactions in
two or more markets.

– Relationship between spot prices and futures

prices – Basis
– Relationship between prices of two futures
contracts – spread
 Arbitrage …

Mathematically,
F(o,n) = So (1+c)
F(o, n) = Futures price of commodity at
‘t =0’ for expiry at ‘t=n’
So = Spot price of commodity at ‘t=0’

c = cost of carry from ‘t=0’ (present) to

‘t=n’(expiry date of contract) expressed as
percentage of spot price
 Arbitrage …

F(o,f) = F(o,n) (1+c) where f>n

F(o,f) = Futures price of commodity at

‘t =0’ for expiry at ‘t=f(far month)’

F(o,n) = Futures price of commodity at

‘t =0’ for expiry at ‘t=n(near month)’

c = cost of carry from ‘t=n(near month)’ to

‘t=f(far month)’ expressed as percentage
 Cash and Carry Arbitrage

• Cash and Carry Arbitrage – between spot and

futures prices
– Buying physical commodity with borrowed funds
and simultaneously selling in the futures contract
in the first transaction and closing the futures
contract by delivering the physical commodity on
maturity in the second transaction.
– When
F(o,n) > So (1+c)
 Reverse Cash and Carry Arbitrage

• Reverse Cash and Carry Arbitrage – lending

funds realized from selling the physical
commodity and simultaneously buying the
futures contract in the first transaction and
closing out the futures contract by taking
delivery of physical commodity on maturity in
the second transaction.
– When,
F(o,n) < So (1+c)
 Is there any Arbitrage Opportunity ?

• Turmeric Contract / Unit of Trading is 30 Quintals

• Spot Price of Turmeric @ Rs. 18,000 per Quintal
• Two-month Futures Contract @ Rs. 18,500 per
Quintal
• Cost of Carry (Interest Rate, Storage and Insurance
Cost,etc.) @ 10 per cent of Spot Price per annum
(Simple Interest)
• What you will do ?
 Is there any Arbitrage Opportunity ?

• Turmeric Contract / Unit of Trading is 30 Quintals

• Spot Price of Turmeric @ Rs. 18,500 per Quintal
• Two-month Futures Contract @ Rs. 18,600 per
Quintal
• Interest Rate @ 10 per cent per annum (Simple
Interest)
• What you will do ?
 Trading Mechanism
Commodity Future Exchanges
 Trading Days and Hours
• Monday to Friday
– Agricultural Commodities :
10:00 AM to 5:00 PM
– Other than Agricultural Commodities
• Bullion, Metals, Energy and Plastics

10:00 AM to 11:30 PM
• Saturday (all commodities)
10:00 AM to 2:00 PM
• Holidays notified in advance
 Electronic Market Place

• Real time, Online, Automated trading facilities

• Satellite-based communication network – VSAT

• Trading also possible through Internet

• Small users through broker in nearby town

 Trading Parameters
• Base Price – First Day of commencement of contract
– At the time of making contract available for trading on the system,
the exchange decides its ‘base price’, which is notional price based
on the spot market price of that commodity on previous day.

• Closing Price
– At the end of trading session, the system calculates the closing price
of each and every contract traded on the system
• Weighted average of trades during last 30 minutes

• If less than 10 trades, then weighted average of last 10 trades

• In the whole day less than 10, then weighted average of all trades

• If none, then previous days

 Trading Parameters …

• Dissemination of Open, High, Low and Last Traded Prices

– Through trading system on real time basis

• Life of Futures Contract / Trading cycle

• Expiry Date

• Trader Work Station (TWS)

 Types of Orders
TWS
Best Buy Order
(with Highest Bid Price)
Is matched with

Best Sell Order

(with Lowest Offer Price)

On Price – Time Priority Basis

 Types of Orders …
TWS
Best Buy Order
(with Highest Bid Price)
Is matched with

Best Sell Order

(with Lowest Offer Price)

On Price – Time Priority Basis

MAIZE SEP 2011 - Futures Contract

Time Bid Price Bid Qty Offer Price Offer Qty

B-1 10:05 1001 1 1005 1 C-1

B-2 10:06 1002 1 1004 1 C-2
B-3 10:08 1003 1 1006 1 C-3
B-4 10:10 1006 1 1004 1 C-4
B-5 10:11 1005 1 1007 1 C-5
B-6 10:12 1004 1 1006 1 C-6

55
 Price Related Condition Orders

• Limit Order
– Specifies the Price at (better than) which the trade be executed
– Limit Buy /Sell – Placed below/above existing market price

• Market Order
– Executed at prevailing price on or after submission of such order

• Stop Loss Order

– Stop Loss Buy /Sell – Placed above /below existing market price
– Trigger price
– Stop Loss Sell Order - Example
» Maize Sep 2011 Future Contract purchased @ Rs. 1000
» Want to limit your loss to Rs. 100
» Stop loss sell order @ 900
 Time Related Condition Orders

• Day Order (End of Session)

– Available for execution during the current trading session

• Good Till Date Order

• Good Till Cancelled

• Immediate or Cancel (IOC) – for Large orders

– Modification or Cancellation of Orders

» Time priority will not change if its quantity is decreased