COMMODITY MARKETS

Yogini Karpe

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MODULE I UNDERSTANDING COMMODITY MARKETS

LEARNING OBJECTIVES
On completing this module, you will able to: Define Commodities Know working of physical markets and value chain Key features of the physical markets Understand the regulations related to physical markets Describe the need and objectives of electronic spot exchange Explain the factors affecting the price, Demand and Supply of commodities Understand the effects of demand and supply on market price Understand the features and list the limitations of cash forward transactions Understand the need for an organized exchange for Futures Trading Know the difference between Forward and Futures
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WHAT IS THE COMMODITY?

A commodity refers to any good, merchandise or produce of land that can be bought or sold. A commodity is an article that: - is used for commerce - is movable - has value - can be bought and sold -is produced or used as a subject in a barter or sale

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WHAT IS THE COMMODITY?

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The Chicago Board of Trade (CBOT) defines a commodity as: An article of commerce or a product that can be used for commerce. In a narrow sense, products traded on an authorized commodity exchange. Types of commodities include: agricultural products, metals, petroleum, foreign currency and financial instruments etc.

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Physical Market
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Cash and Carry Market, Spot Market Customized Deal (Quantity, Quality, Price)

VALUE CHAIN
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Producers Assemblers Traders Processors Distributers

Retailers
Consumers
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Key Features of physical Markets in India Setting up Mandis Products Participants Trading Price Clearing, Delivery and Settlement Regulation

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Problems of the physical market

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Lack of proper price dissemination and transparency in price discovery process Very fragmented, isolated and unorganized market Restrictions on interstate movements of goods Lack of proper certification and standardization of commodities Lack of proper warehousing and transport facilities Long chain of intermediaries Processors not allowed to buy directly from cultivators in most states Excessive dependence on and consequent exploitation by money lenders Distress sale by farmers Stock limits in essential commodities High volatility in spot market prices States having different tax and tariff structures
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Electronic Spot Exchange

Need: Very high cost of intermediation Distress sale Price uncertainty making it difficult to predict the market accurately Lack of an effective mechanism to eliminate price risk

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Objectives for setting up Electronic spot Exchange

Develop a common Indian market by setting up a national level electronic spot market with state of the art trading, delivery and settlement facilities that are accessible across the country Provide an effective, transparent method of discovering nationwide spot prices in various commodities Create a market where farmers can get the best prices and receive prompt payments Facilitate better efficiency in procurement and bring down the levels and cost of intermediation 11

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OBJECTIVES FOR SETTING UP ELECTRONIC SPOT EXCHANGE

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Create market where farmers can get the best prices and receive prompt payments Facilitate better efficiency in procurement and bring down the levels and costs of intermediation Create a market where traders, processors and end users can procure agricultural produces at a competitive price without any quality and counterparty risk. Provide quality certification, warehousing facilities and other services Create a structured, organized and standardized spot market to help the futures exchanges in facilitating physical delivery in agricultural commodities

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FACTORS AFFECTING PRICE, DEMAND AND SUPPLY OF

COMMODITIES

Demand

Demand is the relationship between a commoditys price and the quantity of that product that consumers are willing to buy at that price

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Qd= f(P, Pr, I, T, O)

Where, Qd The quantity demanded P The price of the commodity Pr The price of the related commodity
inverse)

(substitute-direct, complementary-

I T O

Income of the consumer The tastes and preferences of the consumer other factors (population size ,supply)
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Continued

DEMAND CURVE
800
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700 600
500 400 300 200 100 0 Price (Rs per kg) Quanity demanded per month #REF! 20 700 1 40 500 60 350 80 200 100 100

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 Law

of demand :
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The law depicting the inverse relationship between demand and price Shift in demand A right (upward) shifts indicates that more of the commodity is demanded at each price level Ex. Increase in the income level or increase in the price of the
complementary product

A left (downward) shifts indicates that less of the commodity is demanded at each price level
Ex. Fall in the price of the substitute, decrease in the price of the price of complementary products, change in the taste or fashion
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FACTORS AFFECTING PRICE, DEMAND AND SUPPLY OF

COMMODITIES

Supply
Supply is the relationship between the price of the commodity and the amount of the commodity are willing to supply at that price at that time Mathematically, the supply function is,: Qs= f(P, Te, C., Pr, W, G, S, O)

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where, Qs P C Pr direct) W G S O

The quantity supplied The price of the commodity the cost of production prices of the related commodities (substitute-inverse, complementary-

weather and seasonality Government policies Carry over stock Other factors

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SUPPLY CURVE
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900 800 700 600 500 400 300 200 100 0

Series 3 Column2 Price (rs per kg for potatoes 1 100 200 350 530 700

Axis Title

20

40

60

80

100
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 Law

of supply
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other things remaining the same, the quantity supplied will increase as the price increases Shift in supply

if supply increases due to better technology, decrease in the cost of production etc, the supply curve shifts right (upwards), meaning more is supplied at the same price. On the other hand, the supply curve shifts left (downward), when the cost of production increases or there is fall in the prices of the complements.

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MARKET EQUILIBRIUM
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A market is said to be in equilibrium when buyers and sellers buy and sell at the given price, without trying to change the quantity or the price The equilibrium price of a commodity is the price at which the quantity demanded equals the quantity supplied At prices above the equilibrium price, the quantity supplied will exceed the quantity demanded, leading to a surplus of the commodity, which would drive the prices down At prices below the equilibrium price, the quantity supplied to the market will come down, while demand will increase, thus leading to a shortage of commodity, which would increase in the price

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CASH FORWARD TRANSACTIONS

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Two types of cash transaction in the physical market 1. Immediate delivery in the spot market 2. Delivery of a specific commodity to the buyer some time in the future - Cash forward contract

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 Forward

Contract
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A forward contract is a bilateral agreement in which a buyer and seller agree upon the delivery of a specified quality and quantity of an asset on a specified future date at a pre-determined price Features of Forward Contract Forward contracts are over the counter (OTC) contracts. They are bilateral contracts and hence are exposed to counter party risks Each contract is custom designed and hence unique in terms of contract size, expiration date and the asset type and quality Generally, only parties to the contract know the price On the expiration date, the contract has to be settled by delivery of the asset. If party wishes to reverse the contract, it has to compulsorily go to the same counter party, which often results in high prices being charged
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Difference between a spot and forward Transaction

1. 2. 3.

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Trading Clearing Settlement In a forward transaction, cash does not changes hands on the date of entering into the contract. While the trading happens on the current day, clearing and settlement happens at the end of the specified period. Hence, in a forward contract, the trading, clearing and settlement do not happen simultaneously as in spot contract
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Limitations of the forward contracts

The contracts are private and negotiated bilaterally between two parties. Therefore, there are no exchange guarantees. The prices are not transparent as there is no reporting requirement There are no regulations for establishing market stability and protection of market players Lack of standardization leads to illiquidity in the absence of a secondary market The profit or loss is realized only on the maturity date Settlement is only through actual delivery or off setting by cash delivery

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FUTURE CONTRACTS

Evolved out of forward contracts Exchange traded versions of forward contracts Future contracts are also agreement to buy and sell a specified quantity of a commodity during a designated month in the future, at a price agreed upon by the buyer and seller at the time of entering into the contract Future contracts are the standardized (quality, quantity, and the date and time and expiry of the contract A future contract need not be settled through physical delivery It can be closed by entering into an equal and opposite contract

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BENEFITS OF FUTURE TRADING

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Price discovery and price dissemination Price risk management Price stability Common platform for all traders Low transaction costs Absence of counter party credit risk Lower credit risk Liquidity

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FORWARDS VS FUTURES
Criteria Characteristics Forward Contracts Over the Counter contracts Bilateral contracts Exposed to high counterparty risk Custom designed Settled by delivery of the asset on expiration date Future Contracts Exchange traded Large number of market participants Insignificant counter-party risk Standardized Settled by payment of differences without any physical delivery of goods
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Determining price Functions of the market

Forward price = spot or the Price discovery based on cash price + cost of carry demand and supply Neither the market nor the exchange has a role to play in a forward transaction Futures markets perform various important economic functions and meet the needs of futures market users

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FORWARDS VS FUTURES
Criteria Advantages Forward Contracts No margin system Customized contracts Future Contracts
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Standard specifications Absence of credit risk High liquidity High leverage Price stabilization Easy access to all market participants Perfect hedge is not possible due to standardization of contracts

Limitations

No exchange guarantees No transparency in prices Profit or loss is realized only on maturity date Settlement only through actual delivery Lack of standardization

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EXERCISE
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1. 2. 3. 4. 5. 6.

Read APMC Act of your respective state Visit the websites of

NCDEX MCX NMCE UCX ACE FMC

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