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A REPORT

ON

COMMODITY DERIVATIVES (HEDGING IN COMMODITY MARKET)

By
Pooja Rajan Mauru
17BSP1890

Aditya Birla Capital

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Enrolment No.17BSP1890
REPORT ON

COMMODITY DERIVATIVES (HEDGING IN COMMODITY MARKET)

By
Pooja Rajan Mauru
17BSP1890

Aditya Birla Capital

A report submitted in partial fulfilment of


The requirements of
PGPM Program of
IBS MUMBAI

____________________
Date of Submission

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Acknowledgement

The internship opportunity with Aditya Birla Capital limited was a great chance for learning
and professional development. Therefore, I consider myself as a very lucky individual as I
was provided with an opportunity to be a part of it. I am also grateful for having a chance to
meet so many wonderful people and professionals who led me through this internship
period.

Bearing in mind previous I am using this opportunity to express my deepest gratitude and
special thanks to the Mr. Nikesh Ruparel, Senior Business Mentor and Mr. Iqbal Singh
Bansal, Company Guide who inspite of being extraordinarily busy with their duties, took
time out to hear, guide and keep me on the correct path and allowing me to carry out my
project at their esteemed organization and extending during the training.

It is my radiant sentiment to place on record my best regards, deepest sense of gratitude to


Dr. Rachana Sharma, my faculty mentor from IBS, Mumbai, for her careful and precious
guidance which were extremely valuable for my study both theoretically and practically.

I perceive as this opportunity as a big milestone in my career development. I will strive to


use gained skills and knowledge in the best possible way, and I will continue to work on
their improvement, in order to attain desired career objectives.

Sincerely,

Pooja Mauru

Place: Mumbai

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Authorization

I undersigned, hereby authorize the submission of the project work, titled


“Commodity Derivatives (Hedging in commodity market)” the project report
entitled on behalf of Aditya Birla Capital, Undertaken by Ms. Pooja Mauru
(Enrollment No 17BSP1890) as partial fulfillment of the PGPM Program of ICFAI
Business School, Mumbai.

This project work was executed under our guidance and no part of this project has
been submitted for any degree or recognition before.

____________________ ________________________
Dr. Rachana Sharma Mr. Iqbal Singh Bansal
(Faculty Guide) (Company Guide)
ICFAI Business School, Mumbai Aditya Birla Capital Limited.
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Executive Summary

The growth of commodities market has been very significant both in terms of volume and
trade. Commodity markets throughout the world are very volatile in nature. It is believed
volatility in prices is important but extreme volatility is a serious problem for traders
participating in commodity market as they have a fear of incurring huge losses. Hence, the
study mainly focuses on the Indian commodity market. Along with the study on the
commodity market the main objective of the study was to identify the risks associated in
the commodity market and to learn how to eliminate such risks with the help of hedging
strategies. Working on the project of “Hedging in Commodity Market” has helped me to
understand how traders identify and manage the risk while trading with different
commodities with the help of different commodity derivatives. The project had helped me
to understand concept of risk management, types of commodity derivatives and the
participants involved in the commodity derivatives.
All this information has helped me in identifying and managing the risk in commodity
markets, different strategies used to manage the risk which also includes knowledge of
forward market, futures market, spot market and call & put options.

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TABLE OF CONTENTS

Sr. No. Particulars Pg. No.

1 Introduction

1.1 Company Profile

1.2 Industry Profile

2 Main text

2.1 Understanding Commodities

2.2 Commodities Exchanges in India

3 Commoditiy Derivatives

3.1 Commodity Futures

3.2 Commodity Forwards

3.3 Commodity Options

3.4 Commodity Swaps

4 Participants in Commodty Market

5 Trading in Commodity Market

6 Margins

6.1 Basis

7 Risk Management

8 Hedging

8.1 Principles of Hedging

8.2 Advantages of Hedging

8.3 Hedging in Commodity Market

8.4 Practical Hedging

8.5 Limitations of Hedging

9 SWOT Analysis of Commodity Market

10 Conclusion

11 Bibliography

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INTRODUCTION
1.1 COMPANY PROFILE:

Aditya Birla Capital Limited (ABCL):

Aditya Birla Capital Limited (ABCL) is the holding company for all the financial service
businesses of the Aditya Birla Group. With a strong presence across the life insurance,
asset management, private equity, corporate lending, structured finance, general insurance
broking, wealth management, equity, currency and commodity broking, online personal
finance management, housing finance, pension fund management and health insurance
business, ABCL is committed to serve the end-to-end financial services needs of its retail
and corporate customer.

Formerly known as the Aditya Birla Financial Services Limited (ABFSL), ABCL ranks
among the top 5 funds managers in India (excluding LIC) with an AUM of ₹ 2,463 billion
as on March 31st, 2017 and has a lending book of ₹ 388 billion. ABC reported aggregate
revenue from businesses at ₹. 106 billion and profit before tax of ₹. 11.5 billion for fiscal
2016-17. Anchored by over 12,000 employees, ABC has a nationwide reach through over
1,300 points of presence and more than 142,000 agents / channel partners.

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Aditya Birla Group:

Aditya Birla Capital Limited is a part of the Aditya Birla Group, a USD 40 billion Indian
multinational in the league of Fortune 500. Anchored by an extraordinary force of over
120,000 employees, belonging to 42 nationalities, the Aditya Birla Group operates in 36
countries across the globe. About 50 per cent of its revenues flow from its overseas
operations.

Vision:

‘To be a leader and role model in a broad-based and integrated financial services business.’

Mission:

‘To help people to mitigate risks of life, accidents, health and money at all stages and under
all circumstances.’

Values:

 Integrity

 Commitment

 Passion

 Seamlessness

 Speed

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1.2 INDUSTRY PROFILE:

Introduction to Commodity markets and Commodity derivatives:

Commodity trading in food and other agricultural products, metals and energy products
is not a new phenomenon. It is probably one of the most ancient economic activities and,
therefore, it would not be incorrect to state that commodity trading is as old as human
civilization. Over the centuries, commodity trading has undergone tremendous changes,
from the barter system to spot markets to futures markets.

In the past few decades, trading in commodity futures has also evolved from “open-
outcry” methods (which involved trading through a combination of hand signals and
verbal orders in trading pits) to computer-powered electronic trading. Nowadays, big
trade₹ use sophisticated tools such as algorithmic trading (which involves no human
intervention) for trading in commodity futures, and individuals often use mobile phones
for placing orders. As a result, trading in commodity futures around the globe has now
become more sophisticated, convenient and quicker than in the past.

Even though organized commodity derivatives in India began in the 19th century,
commodity futures markets have flourished in recent yea₹ with the onset of reforms to
liberalize the economy in the 1990s. The major steps towards introduction of futures
trading in commodities were initiated in 2004 with the removal of prohibition on futures
trading in all recommended commodities and the setting up of commodity exchanges at
the national level. Since then, the commodity futures markets have witnessed a rapid
increase in trading volumes, market participation and the number of commodities traded.
The commodity futures were initially permitted to trade in agricultural products but
nowadays bullion, metals and energy products dominate the trading volume.

India and other developing countries such as China, Brazil and South Africa have
important commodity derivatives markets. The monthly turnover in Indian commodity
exchanges is next only to the US and China. However, despite rapid growth in trading
volume, the commodity futures markets have frequently courted controversy in India due
to numerous factors, including pervasive market abuses and manipulation that have badly
affected market integrity, weakened integration of spot and futures markets, raised
concerns over price rise, and poor regulation and supervision.

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2. Main Text:

2.1 Understanding Commodities:

Commodities are products that can be bought, sold or traded in different kinds of markets.
Commodities are the raw materials that can be used to create products which are
consumed in everyday life around the world. The commodities are usually traded at a
price resulting from the demand and supply. The two core participants in the commodity
market are the buyers and the sellers. Sellers represent the supply side whereas the
demand side is represented by the buyers. For an appropriate price for the commodities,
auction mechanism for price takes place. Seller ask the buyer to take their product at a
certain price whereas buyers offer a certain price for buying the product. Both the buyer
and seller mutually agree to a common price and exchange takes place. The commodity
exchange takes place with the help of an intermediaries, agents and brokers.

Types of commodities:

 Hard Commodities- natural resources that need to be mined or processed such as


crude oil, gold, silver and rubber.

 Soft Commodities- agricultural products such as corn, wheat, coffee, cocoa, sugar
and soybean; and livestock.

Under Hard Commodities:

Industrial Metals Precious Metals Energy

Zinc Gold Crude oil

Copper Silver Natural Gas

Nickel Platinum Furnace oil

Aluminium Power

Palladium

Lead

Tin

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Under Soft Commodities:

Agricultural Products

Sugar

Pulses

Cereals

Spices

Fibres

Oil and Oil seeds

Livestock

Different Segments in Commodity Market:

 Over the Counter Market

 The Exchange based Market

Over the Counter Market:

Over the Counter market is a decentralized market, without a central physical location,
where market participants trade with one another through various communication modes
such as the telephone, email, and proprietary electronic trading systems. An over-the-
counter (OTC) market and an exchange market are the two basic ways of organizing
financial markets. A trade can be executed between two participants in an OTC market
without others being aware of the price at which the transaction was completed. In general,
OTC markets are typically less transparent than exchanges and are also subject to fewer
regulations.

Exchange Based Market:

In a market that operates with exchange trading, transactions are completed through a
centralized source. In other words, one party acts as the mediator connecting buyers and
sellers. There is a specified number of traders that will trade on that single centralized
system. This situation places great power on the mediator, and this is a key disadvantage

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to this type of trading. The positive aspect to this is that it allows for better transaction.

2.2 Commodity Exchanges in India

 Multi-Commodity Exchange (MCX)

 National Commodity and Derivatives Exchange (NCDEX)

 National Multi-Commodity Exchange (NMCE)

 Indian Commodity Exchange (ICEX)

Multi-Commodity Exchange (MCX)

Multi Commodity Exchange of India Ltd (MCX) is an independent commodity


exchange based in India. It was established in 2003 and is based in Mumbai. It was
established in June 2003 and head quarted in Mumbai. This exchange is the world’s largest
exchange in silver and silver mini and second largest exchange in trading gold, copper and
natural gas and third largest in Crude oil. It was the first exchange in India to offer futures
trading in steel, crude-oil and almond. Commodities traded include metals, bullions, agro-
commodities and energy.

National Commodity and Derivatives Exchange (NCDEX)

National Commodity & Derivatives Exchange Limited is an online commodity exchange


based in India. It has an independent board of directors and provides a commodity exchange
platform for market participants to trade in commodity derivatives. It was founded on
December 2003 and head quarted in Mumbai. The subsidiaries of NCDX are NCDEX Spot
Exchange Limited, NCDEX Institute of Commodity Markets & Research., Power Exchange
India Limited. NCDEX is the only commodity exchange in India promoted by national
institutions and regulated by the Securities and Exchange Board of India (SEBI).

National Multi-Commodity Exchange (NMCE)

The National Multi Commodity Exchange of India Ltd. (NMCE) was launched on
November 26, 2002 as India's first online, demutualized commodity exchange by a group
of Indian commodity-based corporations and public agencies and listed its first contracts on

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24 commodities in November 2002. The NMCE merged with the Indian Commodity
Exchange, (ICEX) in 2017. The combined exchange is India's third-largest commodities
market offering contracts on oils and oil seeds, coffee, rubber and spices, ranked behind
the Multi-Commodity Exchange (MCX) and the National Commodity & Derivatives
Exchange (the Multi-Commodity Exchange).

Indian Commodity Exchange (ICEX)

ICEX was the fourth exchange commodities exchange to open in India, launching in 2009
but it closed in 2014.As of now, The Indian Commodity Exchange is the third largest
commodities exchange in India. It merged with the National Multi-Commodity
Exchange (NMCE)in 2017.ICEX gets final nod from Sebi to restart trading operation. The
exchange offers diamond contracts and plans to offer crude oil and brent crude oil contracts.

Trading of Commodities:

 Spot Market

 Derivatives Market

Spot Market:

In a spot market, a physical commodity is sold or bought at a price negotiated between the
buyer and the seller. The spot market involves buying and selling of commodities in cash
with immediate delivery. There are spot markets for individual consumers (retail market)
and the business-to-business (wholesale market) category. Usually T+2 Cycle is followed
in Spot Market.

Derivatives Market:

Traders in derivative market trade with the help of derivatives contract. A derivative
contract is the one whose value is dependent on the underlying asset. With respect to
commodity market, underlying asset are the commodities. If the value of the underlying
commodity goes up, value of derivative contract goes up and if the value of the underlying
commodity comes down, value of contract comes down.

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3. Commodity Derivatives

Commodity derivatives are usually as a contract whose value is dependent on the underlying
commodity. Underlying commodities are usually non-financial commodities in the
commodity market. E.g. metals like gold, silver, agricultural products like spices, cereals,
livestock, energy like crude oil, natural gas etc. Commodities can be either exchange traded
or over the counter traded. Commodity derivatives act as a double edge sword. They are
used as a risk minimizing tool and used for increasing the profits from exposure to risk.
They are used both by the hedgers and the speculators. Hedgers use commodity derivatives
for risk minimization if the underlying asset (commodity) preventing from adverse market
price fluctuations in future. Hedgers are usually interested in taking the physical delivery of
the asset Speculators use derivatives to increase their profits by increasing their risks.

Types of Commodity derivatives

 Commodity Futures

 Commodity Forwards

 Commodity Options

 Commodity Swaps

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3.1 Commodity Futures

Commodity futures are the most widely used derivative contract. A commodity future
contract is agreement to buy or sell a predetermined amount of a commodity at a specific
price on a specific date in future. Buyers use such contracts to avoid the risks associated
with the price fluctuations of the futures underlying commodity. Sellers use futures
contract to lock in the guaranteed prices for their products. Commodity future contracts
can be used by speculators to make directional price bets on commodities like raw
materials. Trading in commodity future contracts can be very risky for the inexperienced.
Commodity futures are used in commodity trading for hedging purposes to minimize the
risks. Commodity futures are the most standardized contracts and traded over centralized
exchange.

If price of the underlying commodity goes up, buyer will have a benefit as he gets the
commodity at a lower price and after the delivery of the commodity he can resell it at a
higher price in the market.

On the other hand, if price of a commodity goes down, the seller will have a profit as he
sold the commodity from the price greater than the market.

Commodity futures through an example:

A farmer produces wheat which will mature in three months. The current price of the wheat
is ₹ 20/- per kg. The farmer is uncertain about the prices of the wheat whether it will go up
or down in next 3 months. The price can either increase to ₹. 24/- per kg or decrease to ₹.
16/- per kg.

If the price rises to ₹. 24/- per kg the farmer makes a profit of ₹.4/- per wheat bag and at
the same time if the price falls down to ₹. 16/- per kg he will incur a loss of ₹. 4/-

The above paragraph was from the seller’s perspective i.e. the wheat producer.

From the buyer’s perspective,

A flour maker who makes flour out of wheat wants to buy wheat.

Cost of wheat = ₹. 20/- per kg

Cost of production= ₹.5/-

Selling price of flour= ₹. 25/-

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Just like the farmer, the flour maker is also concerned about the prices of the wheat which
will either go up or down. The selling price of flour depends on the cost of wheat.

As the prices can fluctuate and can go up to ₹. 24/- or decrease to ₹. 16/- ,

If the prices are increased to ₹. 24/- per kg, the price of wheat increases due to which the
flour maker makes a loss of ₹. 4/- as prices rose from ₹. 20/- to ₹. 24/-.

On the other hand, if price decreased to ₹. 16/- per kg, the price of wheat decreases due to
which the flour maker makes a profit of ₹. 4/- as prices decreased from ₹. 20/- to ₹. 16/-

From the entire scenario, the observance is that profits and losses for both the buyer (flour
maker) and the seller (farmer) is opposite.

If one is making the profit is other is incurring a loss and vice-versa.

To eliminate such kind of losses, futures contract are formed.

The farmer and the flour maker enters into a contract, in which the farmer agrees to sell
the wheat at ₹. 20/- after 3 months of its maturity and the four maker agrees to buy it from
the respective farmer at ₹. 20/- irrespective of the current prices being higher or lower.

Such kind of contracts used for eliminating risks for both buyer and seller are known as
Futures Contract.

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3.2 Commodity Forwards

A forward contract is an agreement to buy or sell an asset on a specified date for a specified
price. 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. The other
party assumes a short position and agrees to sell the asset on the same date for the same
price. Other contract details like delivery date, price and quantity are negotiated bilaterally
by the parties to the contract. The forward contracts are normally traded outside the
exchanges.

The salient features of forward contracts are:

1. They are bilateral contracts and hence exposed to counterparty risk.

2. Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.

3. The contract price is generally not available in public domain.

4. On the expiration date, the contract has to be settled by delivery of the asset.

5. If the party wishes to reverse the contract, it has to compulsorily go to the same
counterparty, which often results in high prices being charged.

Commodity forwards through an example:

If A has to buy a commodity 6 months from now, and B has to sell the commodity worth

₹. 100/-

They both agree to enter into a forward contract of ₹. 104/-

Suppose after 6 months the price of the commodity is ₹.110/-

A overall made a gain of ₹. 6/- while B made a loss of ₹. 6/-

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3.2 (a) Limitations of Forwards Contract

Forward markets world-wide are afflicted by several problems: –

 Lack of centralization of trading

 Illiquidity

 Counterparty risk

In the first two of these, the basic problem is that of too much flexibility and generality.

The forward market is like a real estate market in that any two consenting adults can form
contracts against each other. This often makes them design terms of the deal which are
very convenient in that specific situation,but makes the contracts non-tradable.
Counterparty risk arises from the possibility of default by any one party to the transaction.
When one of the two sides to the transaction declares bankruptcy, the other suffers. Even
when forward markets trade standardized contracts, and hence avoid the problem of
illiquidity, still the counterparty risk remains a very serious issue.

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3.3 Commodity Options:

Commodity options are options where the underlying asset is a commodity or a commodity
index. Commodity options are basically derivatives products like futures contract but are
different in terms. Options are a contract permitting the option buyer and the sell the right,
but not the obligation to buy or sell an underlying asset in form of commodity, such as
precious metals, oils or agricultural products at a designated price and a designated date.
The option holder will exercise the option only it is beneficial for him, otherwise he will
let the options lapse. Options are primarily used to manage risks or generate premium
income through asymmetric risk exposures to the underlying asset price movements.
Expiry date for all the commodity options are last Thursday of every month. Commodity
options are available in both exchange traded and OTC form (Over the counter).

In options contract, from buyer’s perspective risk is limited for the buyer of the option
whereas profits are unlimited.

Whereas, from seller’s perspective profit is limited to the extent of premium amount paid
by the buyer of the option contract whereas risk is unlimited.

Commodities

Risk associated (Either Profit/ Loss)

To minimize the risk

Derivative Contracts are available

Futures Contract Options Contract

Call Put

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3.3 (a) Terminologies in Options:

 Strike Price: It is the pre-agreed price for which the commodity may be bought or sold
under the option contract. It is also known as the exercise price.

 In the money:

 Call options: Since call options are purchased by traders who are probable of rising
prices in future. If the commodity price is above the strike price it is known as in the
money. Eg. If a call option has a strike price of Rs.50 for a commodity and the current
commodity price is Rs. 55. It is known as in the money.

 Put options: Since put options are purchased by traders who are probable of falling
prices in future. If the commodity price is below the strike price it is known as in the
money. E.g. if a put option has a strike price of Rs. 50 for a commodity and the current
price is Rs. 45. It is known as in the money.

 Out of the money:

 Call options: Since call options are purchased by traders who are probable of rising
prices in future. If the commodity price is below the strike price it is known as out of
the money. E.g. if a put option has a strike price of Rs. 50 for a commodity and the
current price is Rs. 45. It is known as out of the money.

 Put Options: Since put options are purchased by traders who are probable of falling
prices in future. If the commodity price is above the strike price it is known as in the
money. Eg. If a call option has a strike price of Rs.50 for a commodity and the current
commodity price is Rs. 55. It is known as out of the money.

 At the money:

 For both call and put options when the strike price is equal to the current prices it is
known as at the money.

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3.3(b) Types of Options:

 American Style Options

 European Style Options

American Style Options:

The buyer of the option can choose to exercise his option at any given period of time
between the purchase date and the expiry date. This gives a lot of flexibility to the option
holder to get maximum profit out of the option, by exercising the option in the best
manner.

European Style Options:

The buyer of the option can choose to exercise his option only at a pre-determined date.
He does not have the possibility to execute the option before the maturity date and hence
it has only limited ability to take advantage of the fluctuating prices.

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3.3 (c) Call Options

A call option is a contract that gives the owner of the call option the right, but not the
obligation to buy the underlying asset by a specified date at a specific price. It is an option
which gives a right to buy the underlying at the strike price.

Call options are exercised at the expiry if the commodity price rises above the strike price
and not if it is below.

Following is the example how call options can be exercised in the commodity market.

Below mentioned strike prices are for the aluminium, with lot size of one MT (metric
ton)=1000 kgs.

Premium price for purchasing those call options are Rs 10/-

Therefore, premium for purchasing one lot of aluminium is Rs. 10* 1000 kgs = Rs.
10000/

(C.A) Rs.
Strike
800Price Rs.800

In the money

(C.A)
R Strike Price Rs.700

At the Money (C.A) Strike Price Rs.600 Current Price

(C.A) Strike Price


Out of the money Rs. 500

(C.A) Strike Price


Rs. 400

In the above example, the lot size for options trading in aluminium is 1000 kgs.

Different strike prices are given for call options, where the current price is Rs. 600.
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In the mentioned example,

Strike price of Rs. 600 is known as at the money as the current price is also Rs 600.

Strike prices of Rs 700 and Rs. 800 is in the money as they are above the current prices.

Strike prices of Rs 500 and Rs. 400 are out of the money as they are below the current
prices.

 If the price of the aluminium rises from Rs. 600 to Rs. 800

(Profit*lot size-premium price spent for purchasing the option)

Rs.200*1000 kgs- Rs.10000

200000-10000

Rs. 195000/-

 If the price of the aluminium falls from Rs. 600 to Rs. 400

Since in options, we only purchased the option contract of the aluminium and not the
aluminium it depends on the trader whether to buy the commodity or not depending on
whether is gaining a profit or loss.

Therefore, in this case the loss will be only the amount spent on buying the option contract
i.e the premium of Rs. 10000/-

From this, we can observe the difference between the ratio of profits and losses.

From the above example we can conclude the following:

Limited Loss Call (buy) Unlimited Profit-Premium Price

Limited profit Call (sell) Unlimited Loss

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3.3(d) Put Options

A Put option is a contract that gives the owner of the put option the right, but not the
obligation to sell the underlying asset by a specified date at a specified price.

Put options are exercised at expiry if underlying commodity price falls below the strike
price and not if it rises above the strike price.

Following is the example how put options can be exercised in the commodity market.

Below mentioned strike prices are for the aluminium, with lot size of one MT (metric
ton)=1000 kgs.

Premium price for purchasing those put options are Rs 10/-

Therefore, premium for purchasing one lot of aluminium is Rs. 10* 1000 kgs = Rs.
10000/

(C.A) Strike Price Rs.800

Out of the money

(C.A)
R Strike Price Rs.700

At the Money (C.A) Strike Price Rs.600 Current Price

(C.A) Strike Price


In the money Rs. 500

(C.A) Strike Price


Rs. 400

In the above example, the lot size for options trading in aluminium is 1000 kgs.

Different strike prices are given for put options, where the current price is Rs. 600.

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In the mentioned example,

Strike price of Rs. 600 is known as at the money as the current price is also Rs 600.

Strike prices of Rs 700 and Rs. 800 is out of the money as they are above the current price.

Strike prices of Rs 500 and Rs. 400 are in the money as they are below the current price.

 If the price of the aluminium rises from Rs. 600 to Rs. 800

 Since in put options, we expect the prices to go down and here the prices have gone
up from Rs. 600. We purchased the option contract of the aluminium and not the
aluminium it depends on the trader whether to buy the commodity or not depending
on whether is gaining a profit or loss.

 Therefore, in this case the loss will be only the amount spent on buying the option
contract i.e the premium of Rs. 10000/-

 If the price of the aluminium falls from Rs. 600 to Rs. 400

(Profit*lot size-premium price spent for purchasing the option)

Rs.200*1000 kgs- Rs.10000

200000-10000

Rs. 195000/-

From this, we can observe the difference between the ratio of profits and losses.

From the above example we can conclude the following:

Unlimited Profit- premium price Put(Buy) Limited Loss

Unlimited Loss+ Premium Price Put (sell) Limited Profit

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3.3(e) Option Strategies

Long Call Strategy:

A trader is said to be a long call option if he has purchased more than one commodity call
options and expecting the commodity current price to go above the strike price. The person
that buys the commodity option is said to be in the ‘long position’ whereas the person who
sells the commodity call option is said to be in the ‘short position’. Long calls are strictly
bullish strategy.

Buying a long call would result in unlimited profits out of which the premium paid for
buying the options will be deducted if the prices go up than the strike price whereas losses
are limited to the extent of the premium paid.

Limited Loss ---------------------- Call (buy)--------------------Unlimited profits-premium

Short Call Strategy:

A trader is said to be a short call option if he has sold more than one commodity call options
and expecting the commodity current price to go below the strike price. Short calls are for
people who believe in bearish markets.

Selling a long call will result in unlimited loss if the commodity prices go above the strike
prices whereas profits are limited to the premium received by the seller of the option.

Limited Profit----------------------Call (sell)------------------Unlimited loss

In the above patterns showed,

Left side will happen in both the cases if prices increase and right side will happen if prices
decrease.

Long Put Strategy:

A trader is said to be a long put option if he has purchased more than one commodity put
options and expecting the commodity current price to go below the strike price. Long puts
are for people who believe in bearish markets.

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Buying a long put would result in limited losses to the extent of premium paid to the option
seller if prices go above the strike prices whereas profits are unlimited after deducting the
premium paid to the option seller.

Unlimited profits-premium------------------Put(buy)------------------- Limited Loss

Short Put Strategy:

A trader is said to be a short put option if he has sold more than one commodity put options
and expecting the commodity current price to go above the strike price. Short calls are for
people who believe in bullish markets.

Selling a short put would result in unlimited loss if the prices fall beyond he strike prices
whereas limited profit if the prices go above the strike prices.

Unlimited loss--------------------------Put(Sell)-------------------------Limited Profit

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3.4 Swaps

A swap transaction is one where two or more parties exchange (swap) one pre-determined
payment for another.

There are mainly three different types of swaps.

 Interest rate swaps

 Currency swaps

 Commodity swaps

Commodity swaps

A commodity swap is an arrangement by which one party (commodity user/buyer) agress


to pay fixed price for a designated quantity of commodity to the counter party (commodity
producer/seller), who in turn pays the first party a price based on prevailing market price
for the same quantity.

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4.Participants in the Commodity Market:

Day Traders:

Day Traders are those participants who take positions in futures contracts for a single day
and liquidate them prior to the close of the same trading day. The scalpers have the shortest
time horizon. They hold their positions for a few minutes while day traders close their
positions before the end of trading each day. Both the scalpers and the day trade₹ attempt
to make profit out of the intraday movement in commodity futures prices. They do not
carry over their position to the next trading day. These market players provide liquidity in
futures market due to large volumes of transactions undertaken by them. However, it needs
to be acknowledged that such players can also negatively affect the price formation and
market functioning due to excessive reliance on speculative trading.

Hedgers:

Hedgers are essentially players with an exposure to the underlying commodity and
associated price risk – producers or consumers who wish to transfer the price risk on to the
market. The futures markets exist primarily for hedgers. The hedgers simultaneously
operate in the spot market and the futures market. They try to reduce or eliminate their risk
by taking an opposite position in the futures market on what they are trying to hedge in the
spot market so that both positions cancel one another. They operate in the spot market to
buy or sell the physical commodity, and in the futures market to offset any loss arising out
of price fluctuations in the spot market.

Speculators:

Speculators are traders with no genuine commercial business to the underlying; they do
not hedge but trade with the objective of making profits from movements in prices. The
speculators generally assume higher risk and also expect a higher return on their
investments. They do not have any real need to buy, sell or take delivery of the actual
commodities. They wish to liquidate their positions before the expiry date of the contract
and carry out a purely financial transaction. Due to the margin system, speculators operate
in the futures market with minimum investments. The speculators may be professional
institutional investors dealing in big contracts or small individual traders who trade on their
own accounts. The speculators are supposed to provide market liquidity as the number of
those seeking protection against declining prices is rarely the same as the number of those
seeking protection against rising prices.

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Arbitrageurs:

Arbitrageurs are traders who buy and sell to make money on price differentials across
different markets. They simultaneously buy or sell the same commodities in different
markets. Arbitrage keeps the prices in different markets in line with each other. Usually,
such transactions are risk-free.

Arbitrage is a risk-less profit realized by simultaneous trading in two or more markets.


However, arbitrage opportunities are very desirable but not easy to uncover, as they do not
last longer since the prices get adjusted soon with buying and selling Arbitrage is possible
when one of the three conditions is met:

 The same asset must trade at the different prices on all markets.

 Two assets with identical cash flows must trade at different prices.

 An asset with a known price in the future, must trade today at a different price than
its future price discounted at the risk-free interest rate.

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5.Trading in Commodity Market

There are few important terms which are very important for trading in commodity market.

 Margin Money

Margin money is the security deposit given by the trading members to the exchange in
order to deal in different contracts listed over there. The clients deposit this money with
the members who in turn transfer it to the respective exchanges. The aim of margin
money is to minimize the risk of default by either counter party. The amount of initial
margin is so fixed as to ensure that the probability of loss on account of worst possible
price fluctuation (which cannot be met by the amount of ordinary/initial margin) is very
low. In futures trading, the entire value of a contract need not be paid, rather a margin
that is typically between 2 per cent and 10 per cent of the total value of the contract need
to be paid while entering into the contract.

Margin requirements for commodity can be found out through any platform’s Spam
Margin Sheet.

Since, the training was conducted under the sharekhan platform.

The following steps are followed:

Visit to www.sharekhancommodity.com

Scroll down and open the MCX spam margin sheet or the NCDEX spam margin sheet.

The Spam margin sheets will let us know the margin requirements for any commodity
and the profit/ loss for any movement in the prices of commodities.

Example for Margin requirement:

If Rama buys silver futures and margin is 7% by investing worth ₹. 7000 she can buy
future contract which is worth ₹. 100000.

If the price increases by 5% she has the potential of earning ₹.5000 by investing just the
margin amount of ₹. 7000 instead of the entire contract amount which is ₹. 100000.

This is beneficial for investors who do not have huge amount for investment and can
invest which the help of margin money.

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The above screenshot is downloaded from the sharekhan website which is the MCX
spam margin sheet which lets you know the initial margin amount required to trade in
commodities.

Example:

The 1st commodity in the excel sheet which is FUTCOM(aluminium) has an expiry date
of 30th April, it indicates the commodity contract will expire on the respective date
followed by LTP which is the price of the commodity which is ₹. 165.35 which is for 1
kgs but to trade in commodity market quantity lot size is taken into consideration, the
respective trade₹ have to trade according to the mentioned lot size, in our example to
trade in FUTCOM(aluminium), 1MT lot is the criteria which is equivalent 10 kgs which
amounts to ₹. 165350 which is the lot value but the advantage of margin money is that
for trading 10 kgs of FUTCOM (aluminium) the minimum amount required to trade is
₹.20620.27 which is mentioned in the span margin coloumn in the above excel sheet.

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6.Types of Margins

Different margins payable on futures contracts are:

(i) ordinary/initial margin,

(ii) mark-to-market margin,

(iii) special margin,

(iv) volatility margin

(v) delivery margin

(i) Initial/ordinary margin: It is the amount required to be deposited by the market


participants in his margin account with clearing house before they can place order to buy
or sell futures contracts. This must be maintained throughout the time their position is
open and is returnable at delivery, expiry or closing out. When a futures trader enters into
a futures position, he or she is required to post initial margin of an amount specified by
the exchange or clearing organization. Thereafter, the margin becomes "marked-to-
market" and the margin account will be adjusted automatically according to the changes
in futures price

(ii) Mark-to-Market (MTM or M2M): At the end of every trading day, the margin
account of the trader / client is adjusted to reflect the participant’s gain or loss. The price
changes on the close of every trading day may result in some gain or loss as compared
to the previous day’s closing price. These price variations are netted into the daily margin
account. This process is known as marking to the market. Mark-to-market margins
(MTM or M2M) are payable based on closing prices at the end of each trading day. These
margins will be paid by the buyer if the price declines and by the seller if the price rises.
This margin is worked out on difference between the closing/clearing rate and the rate of
the contract (if it is entered into on that day) or the previous day's clearing rate. The
Exchange collects these margins from buyers if the prices decline and pays to the sellers
and vice versa. Collecting mark-to-market margin on a daily basis reduces the possibility
of accumulation of loss, particularly when futures price moves only in one direction.
Hence the risk of default is reduced.

iii) Special Margin/Additional Margin: It is the additional margin imposed by the


exchange to curb excess volatility in the market. Again, this varies from commodity to
commodity.

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(iv) Maintenance margin: It is the minimum level at which the equity in a futures account
must be maintained. If the equity in an account falls below this level, a margin call will be
issued, and funds must be added to bring the account back to the initial margin level. The
maintenance margin level generally is normally 75 per cent of the initial margin
requirement. If the amount of money in the margin account falls below the specified
maintenance margin, the futures trader will be required to post additional variation margin
to bring the account up to the initial margin level and if the futures position is profitable,
the profits will be added to the margin account.

(v) Delivery period margin: It is the extra margin imposed by the exchange on the contracts
when it enters the concluding phase (starts with tender period and goes up to delivery /
settlement). This amount is applicable on both the outstanding buy and sell positions.

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6.1 Basis
The basis is an indicator for the difference between the local cash price and the futures
price for a specific commodity. The basis for a commodity can play an important role in
determining a hedging strategy and can help predict a final price for a commodity when
using a hedge.
A basis for a commodity is calculated using the following formula:

Cash price – Futures price = Basis

A basis can be influenced by the following factors: transportation costs, local supply and
demand conditions, interest and storage costs and profit margins. The basis can change
depending on these factors. When the basis is becoming more positive it is called
strengthening and when it is becoming more negative it is called weakening. It is
important to monitor the developments of the basis, because it provides an indication for
both buyers and sellers how to hedge their price risk and predict a final price for their
product. The basis tends to be consistent despite price fluctuations and can be considerably
accurately predicted using historical patterns. It is therefore very useful for determining
when and what portion of your risk to hedge, or perhaps not to hedge at all.

 When a basis is strengthening this is advantageous to a seller or short hedger of


a commodity. This means the difference between the cash and futures price is becoming
more positive and thus a seller will receive a higher cash price when selling his product
on the cash market.
 When a basis is weakening this is advantageous to a buyer or longer hedger of
a commodity. Because the difference between the cash and futures price is becoming
more negative. This results in the option to buy the product at a lower price and thus
generate an extra profit.

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7.Risk Management
Risk can be explained as uncertainty and is usually associated with the unpredictability of
an investment performance. All investments are subject to risk, but some have a greater
degree of risk than others. Risk is often viewed as the potential for an investment to
decrease in value.

Derivatives are the instruments most commonly used in Financial risk management.
Because unique derivative contracts tend to be costly to create and monitor, the most cost-
effective financial risk management methods usually involve derivatives that trade on well-
established financial markets. These standard derivative instruments include options,
futures contracts, forward contracts, and swaps.

To Manage such risks derivatives are used for minimizing the risks via hedging in
commodities market.

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8.Hedging

Many participants in the commodity futures market are hedgers. They use the futures
market to reduce a particular risk that they face. This risk might relate to the price of wheat
or oil or any other commodity that the person deals in. 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. By selling his crop forward, he obtains a
hedge by locking in to a predetermined price. Hedging does not necessarily improve the
financial outcome; What it does however is, that it makes the outcome more certain.
Hedge₹ could be government institutions, private corporations like financial institutions,
trading companies and even other participants in the value chain, for instance farmers,
extractors, millers, processors etc., who are influenced by the commodity prices.

Hedging is an insurance method for commodity traders, producers and end-users to cover
themselves against negative price movements. Hedging is not used to make profits but
rather to prevent or at least minimize possible losses. The futures exchange is commonly
used to hedge against price risks. Market participants obtain derivatives on the exchange
to cover themselves against price movements. These futures contracts and options on
these exchanges are rarely executed. The position will be offset, which means obtaining
an opposite contract to settle the contract. The commodity will then be sold on the cash
market and the profit or loss made by offsetting the futures position will be added to the
final cash price. The possible profit or loss is then covered by the profit or loss made by
the futures contract.

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8.1 Principles of hedging
When an individual or a company decides to use the futures markets to hedge a risk, the
objective is to take a position that neutralizes the risk as much as possible. Take the case
of a company that knows that it will gain `1,00,000 for each 1 rupee increase in the price
of a commodity over the next three months and will lose `1,00,000 for each 1 rupee
decrease in the price of a commodity over the same period. To hedge, the company
should take a short futures position that is designed to offset this risk. The futures
position should lead to a loss of `1,00,000 for each 1 rupee increase in the price of the
commodity over the next three months and a gain of `1,00,000 for each 1 rupee decrease
in the price during this period. If the price of the commodity goes down, the gain on the
futures position offsets the loss on the commodity. If the price of the commodity goes up,
the loss on the futures position is offset by the gain on the commodity.
There are basically two kinds of hedges that can be taken. A company that wants to sell
an asset at a particular time in the future can hedge by taking short futures position. This
is called a short hedge. Similarly, a company that knows that it is due to buy an asset in
the future can hedge by taking long futures position. This is known as long hedge.

Short Hedge
A short hedge is a hedge that requires a short position in futures contracts. A short hedge
is appropriate when the hedger already owns the asset, or is likely to own the asset and
expects to sell it at some time in the future. For example, 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 can also be used when the asset is not owned at the moment but is likely to
be owned in the future.
For example, an exporter who knows that he or she will receive a dollar payment three
months later. He makes a gain if the dollar increases in value relative to the rupee and
makes a loss if the dollar decreases in value relative to the rupee. A short futures position
will give him the hedge he desires.
Long Hedge
Hedges that involve taking a long position in a futures contract are known as long
hedges. 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.

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8.2 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.
2. Hedging protects inventory values. For example, a merchandiser with a large, unsold
inventory can sell futures contracts that will protect the value of the inventory, even if the
price of the commodity drops.
3. Hedging permits forward pricing of products. For example, a jewellery manufacturer
can determine the cost for gold, silver or platinum by buying a futures contract, translate
that to a price for the finished products, and make forward sales to stores at firm prices.
Having made the forward sales, the manufacturer can use his capital to acquire only as
much gold, silver, or platinum as may be needed to make the products that will fill its
orders.

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8.3 Hedging in Commodity Market

Hedging in the futures market is a two-step process. Depending upon the hedger's cash
market situation, he will either buy or sell futures as his first position. For instance, if he is
going to buy a commodity in the cash market at a later time, his first step is to buy futures
contracts. Or if he is going to sell a cash commodity at a later time, his first step in the
hedging process is to sell futures contracts.

The second step in the process occurs when the cash market transaction takes place. At
this time the futures position is no longer needed for price protection and should therefore
be offset (closed out). If the hedger was initially long (long hedge), he would offset his
position by selling the contract back. If he was initially short (short hedge), he would buy
back the futures contract. Both the opening and closing positions must be for the same
commodity, number of contracts, and delivery month.

Example: Assume in June a farmer expects to harvest at least 10,000 kgs of rice during
September. By hedging, he can lock in a price for his rice in June and protect himself
against the possibility of falling prices.

At the time, the cash price for new-crop rice is $8 and the price of November rice futures
is $8.25. The delivery month of November marks the harvest of new-crop rice.

The farmer short hedges his crop by selling two November 5,000 kgs rice futures contracts
at $8.25.

(Farmers do not hedge 100 percent of their expected production, as the exact number of
bushels produced is unknown until harvest. In this scenario, the producer expects to
produce more than 10,000 kgs of rice.)

By the beginning of September, cash and futures prices have fallen. When the farmer sells
his cash kgs of rice to the local elevator for $7.72 per kg, he lifts his hedge by purchasing
November rice futures at $7.95. The 30 gram gain per contract in the futures market
offsets the lower price he receives for his rice to the cash market.

Result- Cash Sale price $7.72/ kg+ futures gain 0.30/g= net selling price $8.02/ bushel.

Had the farmer not hedged, he only would have received $7.72 a kg for his rice- 30 grams
lower than the net selling price he received.

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8. Practical Example of Hedging Copper

1. If Prices rise in the Future.

In the above example,

If a computer maker uses copper for manufacturing computers, he purchases copper every
year. Hence, copper becomes his part of cost of goods sold.

In this case he will always try to reduce the cost of goods sold, copper being a major part
of production, its price plays an important role in the profits and losses of the computer
manufacturer.

Therefore, rather being uncertain about the prices to go up and incur a loss, the computer
maker will rather enter into a futures contract and hedge the losses.

With respect to the mentioned example, hedging performed is as follows:

Single contract is of 300 pounds of copper.

Currently, the price of the copper (May-2018) is Rs. 465 which is also known as spot
price. At the same times its futures (May-2018) is for Rs. 450 which is the future contract
price of the copper.

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If the computer maker hedges one contract i.e. 300 pounds of copper,

After a year, In May-2019 if the price of the copper increases to Rs. 475.

Here’s what happens under hedged and unhedged situations,

Unhedged Situation

As the price rose from Rs.465 to Rs.475 and no precautions were taken, computer maker
has to purchase the computer in the spot market at Rs.475 for 300 pounds

Therefore, under unhedged situation computer maker has to purchase the copper for
Rs.142500.

Hedged Situation

Even though the price rose from Rs. 465 to Rs. 475 as the copper pounds were hedged by
the computer maker through copper futures, purchasing them now at a pre-determined
price would make a difference.

Copper futures purchased were of Rs. 450 and Current price in May-2019 is Rs.475.

Since, the computer maker purchased copper futures a year earlier he need not pay the
current spot price i.e. Rs 475. Instead, he will pay only Rs. 450 for 300 pounds of copper.

By paying Rs. 450 the computer maker had a profit of Rs. 25 per lb(Rs.475-Rs.450).
Therefore, for the entire contract he makes a profit of Rs. 7500.

His net cost for purchasing the copper is (142500-7500) = Rs.135000.

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2. If Prices fall in Future

With respect to the same example,

The hedged and the unhedged circumstances if prices of copper fall in future.

Unhedged Situation

As the prices fall in future from Rs. 465 to Rs. 460. Under unhedged circumstances, the
computer maker has to pay the current spot prices for the copper i.e. Rs.460 for 300
pounds of copper which is Rs. 138000.

Hedged Situation.

Even if the prices fall, but the computer maker has hedged through purchasing copper
futures a year back @ Rs. 450. Hence, he would pay only Rs. 450 for purchasing the
copper.

By paying Rs. 450 the computer maker had a profit of Rs. 10 per lb(Rs.460-Rs.450).
Therefore, for the entire contract he makes a profit of Rs. 3000.

His net cost for purchasing the copper is (138000-3000) = Rs.135000.

This is the beauty of hedging through which we can minimize our risk.

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8.5 Limitations of Hedging

1. Limitation of uncertain amount: Sometimes the traders who are hedging the
commodities may form hedge for a larger quantity of commodity than what is
actually produced which causes the opposite form of exposure and the trader can
occur a huge loss for not fulfilling or unable to complete the contract.

2. Lack of appropriate instruments: Many a times hedgers find difficult to use proper
hedging instruments suitable for their present situation as per their requirement, this
may happen because lack of proper knowledge regarding to commodity derivatives.
Eg: If a derivative of a commodity is not available it becomes difficult for traders to
hedge for the respective commodity.

3. Lack of liquidity and depth: Traders cannot hedge completely all of their transactions,
so by hedging a portion of transactions that affect them they can only reduce the
sensitivity of the minor loss.

4. Setup Cost: Set up cost includes maintaining a separate department for conducting or
performing all the hedging strategies, at times hedging is a very expensive activity if
not followed thoroughly.

5. Reducing the risk can reduce the profits: Hedging reduces the risk by reducing the
volatility of future returns. Cost of hedging can minimize the profits.

6. Conceptually difficult: Hedging as an instrument is a complex mechanism to


understand and implement, as it considers various factors affecting the economy.

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9.Swot Analysis of Commodity Derivatives Market:

Strengths:

 Benificial to farmers: Using hedging as a risk minimizing tool enables those farmers
who grow commodities in large quantities to hold on to their crops and there by
release a better price over a period of time. The futures market provides the farmer
the opportunity to undertake proper crop planning by giving an advance indication
of the expected prices in the near future.
 Benificial to Buyers: Indian commodity derivative market is significant for
consumer because it provides an indication of the price at which commodity would
be available at future point of time. Thus it enables the consumers to make proper
financial planning and also cover their purchases for future price wise by entering
into derivative contracts.

Weakness:

 Inadequate Liquidity: In India several commodities registered in the commodity


market face lack of liquidity. This is because many commodities have been selected
for futures trading without any demand for them. As a result, futures contract are too
narrow with just few deliverable varieties.
 Absence of Commodity Options: In India, trading in commodity options contract
have been banned since 1952. The market for commodity derivatives cannot be
called complete with the presence of an important derivative instrument i.e. options.
Like Futures, options are also an important derivative instrument used for hedging
and speculation purposes.
Opportunities:

 Tax reforms: In the past, speculative and non-speculative businesses in India were
treated equally for taxation right to set off or carry forward of loss was concerned.
However various forms of tax benefit were extended to other financial assets as well as
markets in the Indian financial system. Such incentives were not extended to the Indian
commodity derivative market which subsequently was placed at a disadvantage. The
Indian commodity derivative market has been demanding amendments in the tax law
correcting this discrepancy which stands in the way of growth of futures trading
activity.

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Threats:

 Excessive Speculation: The inherent basis of derivative market is speculation.


Hence excessive speculation in the commodity derivative market can lead to price
inflation in the commodity spot market causing great disruption and pain in the
economy.

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10.Conclusion:
 Very few people are aware about trading in commodity derivatives, even if some
people are aware about it they don’t know the exact way to minimize their risks
with proper use of commodity derivatives. Sebi is taking necessary actions to
create awareness among the traders.
 Hedging as a tool is very difficult for traders to understand and use it effectively
for risk minimisation and along with this is a very costly activity to implement.
 Internationally, commodity derivatives are exchange traded.
 In bullish markets, the traders can earn profit by buying commodity futures.
 In bearish markets, the traders can earn profit by selling commodity futures.

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11.Bibliography:
https://www.scribd.com/
https://www.investopedia.com/
https://www.mcxindia.com/home
https://www.slideshare.net/
www.sharekhancommodity.com

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